The UK downgrade by Moodies has been on the cards for some time and some would say was inevitable given the UK’s current situation

Nevertheless it has always struck one as being slightly incongruous that the ratings agencies (Moodies, S&P, Fitch et al) are given as much credence as they are in the light of their woefully inadequate performance assessing the 2007/08 situation; in fact I am slightly confused why they have not been sued into extinction over that episode

The collapse in 2008 had been on the cards for a considerable length of time with a number of warning signs and yet not only did the rating agencies totally fail to identify the impending problems, they totally underestimated the dimensions of the crisis when it materialised.

To all accounts they were working with economic models that ignored real world drivers and what was even worse was, that they had absolutely no idea that they were operating with flawed models in the first place. Even to the layman, it was obvious that these models failed to accommodate the evolution of real-world events or economy

In other words, a systemic failure of economic interpretation by that profession; placing theory above potentially known outcomes and giving greater weight to the wrong areas. A ‘black swan’ event may have occurred, but it is worth noting that there is no such concept as ‘systemic failure’ in the world of economic models. Surely this in itself is a fundamental flaw in approach, because it does not even recognise the possibility of a total breakdown?

Therefore, because of these flaws the rating agencies (regulator SEC) were, by dint of their influence, themselves a contributory factor in the whole crisis such as:

  • Offering the highest ratings to financial instruments that were far riskier than advertised. Mislabelling some bonds as triple-A, thereby encouraging investors to place their money in incorrectly identified low risk investments i.e. CDO (collateralised debt obligations), RMBS (residential mortgage backed securities) etc.

Don’t forget that some institutions are prohibited from holding low rated securities and the very fact that the ratings agencies incorrectly classified CDO’s etc. placed these investors at greater risk than they were allowed to take on. Furthermore, once these instruments were reclassified correctly, the institutions had to dump them because they were in breach of the rules

Now we come to a conflict of interest by the ratings agencies. After all they are paid by the very firms whose assets there were recommending/rating and giving a low rating was potentially bad for business. So we culminate in a situation of ignoring high-risk packaged loans (fraudulent mortgages) and assigning them with a quality rating status

With all this in mind, it is quite extraordinary how these ratings organisations have managed to survive and maintain their credibility in rating corporate/public debt

The following springs to mind

There are known knowns.
These are things we know that we know.
There are known unknowns.
That is to say, there are things that we know we don't know.
But there are also unknown unknowns.
There are things we don't know we don't know.

(Donald Rumsfeld)

Tags: | Categories: Economics