Thursday, May 6, 2010

Bill Gross Joins the Europeans: Dismiss the Rating Agencies

In his latest Investment Newsletter, Bill Gross stocks the knife on the rating agencies. Indeed, how these agencies are still around and have not been sued to bankruptcy is beyond me.

Please see our post on MCO straddles earlier today.

Says Gross:

"In all of the hullabaloo over Goldman Sachs, a CQ analysis of the rating services – Moody’s, Standard & Poor’s and Fitch – has escaped front-page headlines. Not that a number of observers haven’t been on to them for a few years now, including yours truly. Back in July of 2007 some of you will remember my description of their role in the subprime crisis. “Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels and a ‘tramp stamp.’” Now, it seems, I was a little long on humour and a little short on the reality. Tramp stamp and hooker heels do not begin to describe the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the subprime craze, as well as reflecting the general deterioration of investment common sense during the past several decades. Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbours. The result has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don’t go bankrupt. Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them."

"But I come not to bury the rating services, but to dismiss them. To tell the truth, they can’t really die – they serve a necessary and even productive purpose when properly managed and more tightly regulated. A certain portion of the investment world will always need them to “justify” the quality of their portfolios. Governments and regulatory bodies say so – it’s the law. In 1975 the SEC officially designated the aforementioned three rating agencies as “Nationally Recognized Statistical Ratings Organizations.” For all intents and purposes, that meant that regulated financial intermediaries such as banks, insurance companies and importantly pension funds would be guided by the sanctity of their ratings.
Such services, however, while necessary in the ongoing scheme of financial regulation, are overpriced as well as subject to the influence of the issuer, which in turn muddles their minds and clouds their judgment to say the least. E-mails from S&P employees have been cited discussing massaging subprime statistics in order to preserve S&P’s market share relative to their two competitors. PIMCO’s Paul McCulley said it as only he can – “[The breakdown of our financial system] was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out the fake IDs!”


"No one or no one company has a monopoly on investment or ratings expertise. Second grade intelligence and a high CQ are a rare combination for an individual rating agency or an investment management firm as well. Still, the rating agencies in recent years have displayed little of either. In addition, they have brazenly sold their reputations for unbiased judgment to the very companies they were standing in judgment upon. Don’t bury them however; like vampires in the dead of the night they will outlast us all. Those looking to profit at their expense, however, will dismiss them. They no longer serve a valid purpose for investment companies free of regulatory mandates that can think with a teaspoon of IQ and a tablespoon of CQ.

William H. Gross
Managing Director"

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