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The Ratings Reformation

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Three ways to make them useful - if they're allowed to survive.

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As someone who focuses on equities for a living, I usually don't spend much time thinking about the rating agencies. I recently took a look at them with the thought that they might be beaten up enough to merit a discounted purchase. Indeed, Moody's (MCO) certainly looks cheap if you believe in the viability of its business model.

It's that viability, however, that offers the rub. Moody's and the other rating agencies (Standard & Poor's, Fitch, etc.) enjoy a special status in the financial world. The majority of capital available to invest in our marketplace is restricted as to what it actually can and cannot own according to ratings (primarily Moody's and S&P).

Thus, a large pension fund or insurance company would be forced to sell a security if one of these rating agencies decided to lower the rating on such security. Further, a downgrade in rating could mean hundreds of millions of dollars in incremental funding costs. Simply put, the rating agencies have an enormous amount of power.

Now, if you're an entity that wants access to the credit markets -- just a company looking for a new loan, or to rollover an existing one -- you have to pay homage to the rating agencies. You'll spend time convincing the folks at S&P and Moody's that you deserve a higher rating.

The catch? You get to pay them for that opportunity. So it should come as no surprise that the relationships between the rating agencies and their customers got a bit too cozy. Kind of like a teacher being caught with a young student at a bar a bit too late at night. After all, the rating agencies were being paid by the very people they were supposed to be looking over - actually, judging.

We all know how the story played out. What's really tragic is how completely the rating agencies allowed their brands to be trashed. This is so because they handed out AAA ratings like they were losing lottery tickets. AAA means you cannot lose money. It means the business, the paper, the security is rock solid. It means (or it used to mean) you don't have to think about the investment, for it's safe.

To have an AAA security be downgraded to AA would be a rare event, and would cause enormous ripples. To have an AAA security actually go bankrupt would be unfathomable. But that's exactly what happened. From Enron to American International Group (AIG), the highest rating has been tarnished. It's difficult to put into perspective what a complete failure this is on the rating agency's behalf. It's like calling a fourth grade baseball team the equal of the New York Yankees. It's so bad it's not even close.
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No positions in stocks mentioned.

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