Why the rating agencies are worthless

August 4, 2010
Vilnius, Lithuania

Remember the credit rating agencies– specifically Fitch, Moody’s, and S&P? Among other things, they take on the responsibility of rating the creditworthiness of sovereign nations.

This is a pretty important task that has become critical to the global financial system. Bear in mind, though, these are the guys who slapped perfect ratings on pools of risky mortgages– the ones where they gave no money down loans to people with no job, no income, no assets.

In terms of their sovereign ratings, agencies dish out their best scores to countries like the US and UK which borrow money like degenerate gamblers. Places like Abu Dhabi– which are cash-rich and in excellent financial health– are scored lower. It makes little sense.

Recently, in another brilliant move, S&P warned that the UK’s debt level ‘may prove inconsistent’ with its pristine sovereign rating.

Hardly a bold claim, wouldn’t you say?

British debt, currently at 64% of GDP, is rising every day, just like Spain, Greece, and Portugal; it seems like everyone else in the world has figured this out– a nation that is in debt up to its eyeballs and borrowing record amounts every month is simply not worthy of the world’s best credit rating.

Yet, for whatever reason, it takes the rating agencies’ teams of monkeys several years to wake up and smell reality.

I’ve recently been given an insider’s perspective into this system. A few weeks ago, I made the acquaintance of a person I’ll call “Sal”.  Sal is a high level executive at one of the major rating agencies in London, and we met under casual circumstances.

Personally, Sal and I hit it off instantly… only later did I find out what Sal does for a living. Needless to say, we immediately dove into a rather heated debate about the nature of the financial system.

I argued that rating agencies distort reality by ignoring simple and obvious facts; this has far reaching implications because trillions of dollars are allocated based on these ratings– and I’m not just talking about wealthy investors either.

Pension funds, mutual funds, and money market funds make their capital allocation decisions partly due to the rating agencies’ analyses.  As such, when S&P gets it totally wrong, the consequences affect little old ladies and factory workers just as much as the wealthy.

Believe it or not, most fund managers don’t want to stick their necks out… especially if they’re managing retail money like pensions or mutual funds.

They know that they most likely won’t get fired for following the advice of the rating agencies; if S&P says that Greece has investment-grade debt, and later Greece defaults, the fund manager can always point the finger at S&P’s shoddy analysis.

It’s all part of the very childish financial system blame game.

Ironically, my new friend Sal agreed with all of this, stating very simply “well yeah, but if we downgraded Greece a few years ago, it would have caused a colossal decline in the markets back then… and then people would be blaming us for sparking a crisis.”

OK, wait… so instead of doing your job and publishing a factual analysis, you stuck your head in the sand and waited for it to blow up in everyone else’s face because you’d rather look stupid than a financially conservative?

This logic is like shouting “FIRE!” from outside a crowded theater after it has already burned down to the ground.

China apparently realizes the insanity of this system; in April of this year, Chinese President Hu Jintao said the world needed “an objective, fair and reasonable standard” for rating sovereign debt.

(China’s own rating agency, Dagong Global Credit Rating Co rates the US as the third highest score; it rates China with the second highest along with Germany.)

For individual investors, I think we can look at the situation on the ground and figure out for ourselves that bond yields for these debt-laden countries must rise.

With the UK’s deficit shattering its own record levels, for example, Her Majesty’s Treasury is simply going to have to pay a higher rate in order to attract lenders. That makes today’s gilts an excellent target for shorting.

Britain will fall behind first because its currency is not seen as a safe haven anymore. In the long run, though, the same fate will befall the other traditional safe havens that are drowning in debt.

For example, I saw Bill Bonner speak at a conference recently about why he thought shorting Japanese bonds and buying their mid-cap stocks could be the trade of the decade.

Given that Japanese yields are basically nothing, its government has indebted the nation over 100% of GDP, and mid-cap companies often trade for less than  tangible assets, I am inclined to agree.

About the Author

Simon Black is an international investor, entrepreneur, and founder of Sovereign Man. His free daily e-letter Notes from the Field is about using the experiences from his life and travels to help you achieve more freedom, make more money, keep more of it, and protect it all from bankrupt governments.