Wednesday, August 24, 2011

Rating the ratings agencies

Amid all of the controversy over the downgrade of the United states debt rating from AAA to AA+ by Standard & Poors- which seems to have resulted in the early exit of the President of S&P, Deven Sharma, from his job- it is easy to lose sight of the bigger picture.

In Estonia there has been a mild celebration at a two notch upgrade in the Estonian credit rating to AA-, that is to say only three notches below the United States and just one below Japan (according to Moody's, another one of the big three rating agencies, which now also includes Fitch). The celebration was rather mooted simply because the value of such a rating is no longer the unquestioned blue ribbon it once was. Although, for regulatory reasons, investors are compelled to pay attention to ratings, the fact is that much of the latest credit crisis came about when structures, such as CDOs, which had been rated AAA by the agencies (largely, it should be said, for technical reasons) turned out to be worthless securities after all. The fact is that large firms, such as Goldman Sachs, created structures that would comply with the rating agency rules, but that this compliance was simply cosmetic. The large fees that the banks paid the agencies in order to obtain the ratings were a significant conflict of interest. In the end the co-operation between the two may well end up being considered as a market collusion in order to defraud investors.

It is in that context that the public revelation that Lloyd Blankfein, the head of Goldman, has retained personal lawyers is so significant. Goldman Sachs has come in for some very heavy criticism- and as I have noted in previous blogs, some of this hostility to "the Vampire Squid", may well be justified. It is also interesting to note, without prejudice to Mr. Blankfein's own position, that despite the scale of the crash, there have been remarkably few investigations, let alone prosecutions for activity that -at best- might be described as questionable. Indeed, while banks have been created and destroyed in the crisis, until recently very few Bankers saw much impact on their personal positions. It is only now that we are beginning to see large numbers of bankers losing their jobs.

So the reputation of the ratings agencies has been one of the principal victims of the crisis. Furthermore it underlines how very little of real value has been actually offered by finance professionals. Ratings opinions have often proven worthless, but throughout the finance world, much else has proven to be of highly questionable value. Among the key figures in finance, the fund managers- whether in mainstream funds, or in so-called absolute return funds- have generally delivered sub-market returns. That they do this while still charging high fees (or indeed any fees at all) is now a matter of growing irritation. It is now quite clear that the whole paradigm of modern finance has rested more on chance than on skill, and as a result the rewards for these questionable skills must now fall substantially.

So as countries find their debt ratings moving up or down, the reputation of the ratings agencies -and the reality of the rest of finance, for that matter- has fallen well below investment grade.

I have spent twenty years working in the City of London or on Wall St. Only now, as I get closer to the companies that I invest in, do I see the way in which the financial system has broken down. As the likely decade-long recovery from the "Second Great Depression" slowly advances, it is only now that we are beginning to see that major changes may be coming to the conduct of the global financial system. Those responsible for the failures will now pass, and a new generation will emerge. Along the way I suspect many legal tussles, but the most important recognition will be that the fundamental ideology of finance must be altered. The value destroyed in the crash is greater than the entire value ever added by banks in the whole history of finance.

That alone must tell you that the global financial paradigm is based on a false premise. Finance does not create value: it merely transfers it. Chance is a greater determinate of performance than skill. Under those circumstances, the outlook for those who have made fortunes selling non-existent skills is- and should be- much diminished.

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