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February 06, 2008

The Coming Collapse of International Credit Ratings
by Alex Wallenwein

So you thought the Ambac/MBIA bond insurers crisis was bad?

You ain't seen nothin' yet

The problem, the challenge, the scandal, is not that the bond insurers are about to be downgraded. The real scandal lies in the fact that they haven't been downgraded a long time ago - and much deeper than from "AAA" to "AA". In fact, what needs to be downgraded are the major international credit ratings agencies, Moody's, Standard & Poor, and Fitch.

Ironically, they are already in the process of downgrading themselves. Moody's, for example, recently issued a statement cautioning investors not to rely on its ratings so exclusively. Ha! That's like a corporate CFO saying investors shouldn't rely on the company's financial statements so much when making their decisions.

Why Downgrade the Ratings Agencies?

Why do they need to be downgraded? Because the top three or four ratings agencies are ridiculously behind the curve when it comes to letting investors know about problems with the entities whose credit standing and investment outlook they (pretend to) rate. The reason for that appears to be an unresolvable conflict of interest which emanates from how these agencies get paid. They get paid for their services by the companies (and governments) whose performance they rate.

Somewhere in the distant past, in the early 1970s, they were paid by the investors who needed to tap them for their information so investors could make educated judgments on investment risks. That is no longer so. Now, they serve two masters at the same time - but only one master really gets the benefit: the one who pays them.

Unfortunately, the ones left in the dust in this scenario are the world's institutional and professional investors, and they are largely the ones who most influence the prices of investment products.

What's the Big Deal?

The ratings agencies are the paper investing world's equivalent of an air traffic control system. Particularly institutional investors rely on them almost exclusively when deciding whose debt paper to buy and whose to ditch.

Picture yourself as the pilot of a big airliner. It is nighttime, it's foggy, and you need to land. The question is: are the runway and the landing approach clear? You communicate with the tower of the airport of your destination, and you hear: "Oh sure,go ahead" through your earphones, so you commence your landing approach.

What you don't realize, though, is that the way the air controllers get compensated has just been changed.

No longer do they get bonuses for sterling records of no accidents over a period of time. Now, they get paid extra if they can manage to land as many airliners as possible - simultaneously!

You can probably see where that might cause a little problem.

In other words, you can't rely on the air controllers' directives anymore - but you don't know that. So you crash-land your plane, only narrowly escaping an in-air collision with another plane, and then you start asking questions.

The world's institutional investors are as dependent on the accuracy of the agencies' ratings as airline pilots are on air traffic controllers, but just like in our analogy, the change in payment structure has compromised the interests of the recipient of the information.

One result of this conflict of interest is that, according to an interview with Sean Egan of Egan-Jones Ratings aired on CNBC Friday, February 1, 2008, the ratings agencies' bank and Wall Street investment house customers have actually exerted pressure on the agencies to issue ratings on CDOs - the very subprime mortgage-backed instruments that caused the current credit crunch!

As if that wasn't bad enough, the ratings agencies then reportedly began to demand that bond insurers develop "mutiple streams of income" in order to get their coveted "AAA" ratings - and that entailed insuring CDOs as well, which ultimately benefited their customers, the bankers, who wanted to push that toxic stuff into the markets.

Naturally, the agencies bowed to their masters requests, which in part caused them to sustain the very subprime-related losses they are now being downgraded for. Funny how that works, isn't it?

The Upshot

The upshot of all this is that the entire global professional investing world has traditionally heavily relied on these ratings outfits in making investment decisions. "AAA" ratings that used to be regarded as immovable, solid landmarks in the investment landscape now turn out to be nothing more than shape-shifting phantoms.

In fact Egan-Jones, which is a relatively new ratings agency that decided to follow the old model of getting investors to pay for their services, rates MBIA not "AA" (to where Moody's wants to downgrade it) but only a mere BB+, which is essentially junk status.

There is no telling how many other companies and bond-issuing governmental entities might be affected in a similar way. Quite tellingly, and in anticipation of potential future criticism, Moody's has recently warned that it may have to downgrade the United States of America's credit rating.

There are international efforts underway to "fix" the coming ratings disaster by making the companies adhere to "higher ethical standards. Yeah, right. That has always helped, hasn't it? Just think "Sarbanes-Oxley". The only thing that will fix the problem is to prohibit the ratings companies from accepting money from the institutions they rate. Period.

But, regardless of how, whether, and when the ratings companies themselves will get fixed, the neglect they have shown in the past has caused systemic problems. That malfeasance is opening up a veritable maelstrom, a black hole for international credit ratings. The collective reputation of these agencies has pumped up the value of many bank and government-issued debt instruments for the past three decades - and now that "value" is threatening to collapse.

The question now is: on how many - and on which ones - of these credit ratings did they goof up? Six years ago they failed to timely warn of Enron, Worldcom, and others. Now, it's Ambac and MBIA. Who's next?

The very fact that these agencies have been whitewashing their clients' credit ratings over the past several decades throws every single rating they have issued into doubt.

That means there are likely to be huge numbers of bone-deep ratings cuts coming down the pike - and nobody knows which ones, or how deep those cuts will be.

One thing, however, is almost for certain: The very fact that Moody's has warned of a credit downgrade for the United States indicates that such a downgrade is probably long overdue - and that will spook a whole lot of international US treasury investors - like China, India, Japan, and Saudi Arabia.

Let that sink in for a moment.

When companies and governments get downgraded like this, they must offer far higher returns on their debt paper to attract future investors - and that raises interest rates.

Considering how far these outfits may well appear to be behind the curve, that means the world is anticipating a humongous jump in long term and short term interest rates - and that in spite of the US Fed's desperate and frantic attempts to lower domestic borrowing costs.

Interest Rates Will Have to Rise

Unfortunately, as far as most government bonds are concerned, higher returns mean that a lot of bonds have to be sold because, with bonds, yields are an inverse function of price. For the yield to go up, the price must go down, and that means selling, selling, selling.

The astute investor will anticipate that - and get the hell out of bonds of any kind. And, oh yeah, as interest rates rise across the board, companies will find it more expensive to borrow money, so it gets harder to make profits (which is already pretty damn hard as it is these days) and that means stocks will suffer as well.

Where do you think all of that newly homeless investment capital will go? It will seek a safe haven - but bonds, especially those of the US government kind, will long since have lost that status by then, even in paper investors' minds.

That just about leaves only gold, its precious metallic cousins, and the related investment vehicles such as precious metals ETFs, stocks, and mutual funds with any hope of decent returns.

It will be very interesting to watch this happen: Millions of investors, institutional and private, all rushing to invest in only a handful of companies, while bidding down the price of fiat money.

Got Gold?

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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