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How We Got In This Basket IV

October 5, 2008

Part IV – If You Can’t Trust The Rating Entity, What Does The Rating Mean?

Unfortunately for all of us at the current moment, the market ratings investors rely on are given by the “Nationally Recognized Statistical Ratings Organizations”, or NRSROs. The SEC permits financial institutions to use NRSRO ratings for certain regulatory purposes. For instance, certain types of investment portfolios are only only allowed to trade in AAA rated investments. Some of these are the ones many financial advisors recommend for college and retirement funds.

Until fairly recent reforms in 2005, NRSRO status was granted by the SEC based on the number of people in the market who used the Credit Rating Agency that was applying for . There is now a bit more of an initial investigation, but after approval, oversight is nearly nonexistent.

To add to the problems, during the ’90s, NRSROs began merging. At one point, the number of NRSROs had dropped to 3, whereas for most of the period prior, there were 9. The NRSROs were allowed to completely self police, being required only to inform the SEC if anything changed that might go against their charter or jeopardize their NRSRO status. 

So, who are these NRSROs? You’ve probably heard of some of them. You may even watch their indexes to see how your investment decisions are faring. Standard and Poors is one. So is Moody’s Investment Rating Services. What you may not know is that in June of this year, the SEC, after completing a 10 month investigation into NRSROs Moodys, S&P, and Fitch, issued a press release. In it, Chairman Christopher Cox said that they had “uncovered serious shortcomings at these firms, including a lack of disclosure to investors and the public, a lack of policies and procedures to manage the rating process, and insufficient attention to conflicts of interest.” Cox continues to say that “when the firms didn’t have enough staff to do the job right, they often cut corners.” The SEC has now proposed new rules. Whether or not these restrictions are stringent enough is open to debate.

To sum it all up: we had securities being traded on a market whose perceived risk was tied in great part to the ratings of self policed entities who operated under a Nationally Recognized status. As the housing market declined, it became increasingly obvious that MBSs and CDOs containing subprime and Alt-A mortgages were far riskier than previously thought. The credit swap market being used to back these securities froze up, further increasing their perceived risk. The NRSROs were eventually forced to lower their ratings. As they did so, the value of those securities fell even further. The thing with the market for CDOs and credit swaps is that, unlike the stock market, if no one wants to buy them, the market doesn’t have to trade them at all. Doesn’t even have to open for business. Unfortunately, the value of these items is based on what their current market value is. If there’s no market, they are considered worthless.

And so, we get to the point we’re at now. Suddenly, lots of MBS and CDOs have seen their ratings fall from the highest AAA ratings to, for some, the lowest BBB- ratings. Since no one wants to trade them due to their new risk, the market is closed. A lot of those CDOs and investments were held by both investment and, thanks to deregulation, commercial banks that we have placed our deposits in, and gotten our mortgages from. They make up a very large portion of the operating assets of hundreds if not thousands of financial institutions. This is the basket that has been woven. Which direction the basket goes is still unknown. The bailout plan is an attempt to at least prevent the entire basket from sinking for the time being. But the holes still need to be patched.

Authors Note: All of these explanations have been highly simplified, especially that of the Securities market and CDOs.  There are also many other areas of the market into which regulations need to be at least considered. But these other regulations are far more complex, and more debatable within the economic community. The regulation of ratings organizations, in my opinion, should not be. We must be able to trust that a AAA is a AAA based on its merit alone. In this way, we can avoid the “free market vs. socialism” debate that is brought up every time regulations are considered.

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2 comments

  1. This series is the most informative set of unbiased looks at how we’ve landed where we are.

    Would you consider updating the http://en.wikipedia.org/wiki/Bank_regulation_in_the_United_States page?


  2. I’ll definitely take look at it, and see if there’s anything I can add. Somehow hadn’t run across that page in all the research I did. Thanks for the vote of confidence on the series…nice to know someone was able to get all the way through it!



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