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Rating Agencies and Prophets

Some think rating agencies inevitably take the side of their patrons - to the burden of those who buy these "financial products" in good faith in the objective judgment of the auditors. Of course, the agencies do not accept liability.

The strange masters of the finance markets are now standing naked

By Klaus Anders

[This article published in: Freitag 39, 9/28/2007 is translated from the German on the World Wide Web,  http://www.freitag.de/2007/39/07/390401.php.]

There are far more losers than winners in every great financial crisis. In what category do the rating agencies fall in the present eruptions? Are they a world power on the international money markets? No security and no derivative can be floated without the seal of quality of a rating agency. No debtor, no government, no bank, no investment fund, no one who wants to sell on the finance markets can manage without such a certificate.

Rating agencies live from the inscrutability of the business

Where fictional goods with fictional "worth" are traded, everyone hungers for the reliable "objective" judgment that never occurs. No one can forecast the play of the markets or make prophesies. Whoever speaks on the market about the market immediately influences the market - usually in his own interest. Actors play against each other without knowing one another. Observing each other, they race and flee again and again in the same direction as a frightened herd of sheep. For centuries, the "madness of crowds" has been a well-known picture for the conduct of investors and speculators. In this world of inevitable risk, the players rely on the supposed wisdom of several market seers. Rating agencies are the high priests in this business.


Without rating agencies that distributed the highest grades for years up to the bursting of the real estate bubble, the certified securities, the synthetically "structured" bonds (behind which rotten credits were often hidden) would never have become speculation objects for everyone in the financial world. Without certificates of agencies, hedge funds worldwide would never have relied on these highly risky papers.

Whoever practices a label fraud here can be easily identified. The market is ruled by three giants, the US firms Standard & Poor's, Moody's and the French-British Fitch agency. The "big three" branches divide up 85% of the market. No line has grown as rapidly in the last years for all three as appraisal of credit derivatives.

In business since 1900, Moody's maintains offices in 18 countries today and employs more than 2,100 specialists in Korea, India, China, Russia and Latin America. Standard & Poor's, the oldest firm of the big three, has branches in all important financial sites of the earth and employs over 1200 top-flight analysts including some of the leading financial economists. Fitch grew into a multinational conglomerate after its ratings were adopted in Europe and North America. Today Fitch is in 75 countries with one headquarters in London, another in New York and 40 permanent offices.

The big three continually evaluate the credit-worthiness of thousands of businesses including banks, insurances and investment funds. They continuously issue grades for tens of thousands of securities including loans, shares, bonds, all possible derivatives and "structured financial products" all over the world. This is a billion-dollar business since the rating determines the value of a security on the finance markets. Banks and investment funds that want to sell securities comb the agencies and use the best grades (AAA) to canvass for their financial products. The agencies are paid in a princely way for this. The fees begin at $25,000 per rating. The more complicated the security and the more non-transparent the risks, the higher are the royalties. In the "structured credit derivatives that collapse everywhere, the fees (and the profits) of the agencies are extremely high.

The rating agencies have become glittering businesses. However the financial crises that they cause through careless or adventurous ranking of very dubious securities also strike them. In the second half of July when the financial crises could not be ignored any more, they first6 corrected downward their rating for the most risky mortgage- secured derivatives. This was so drastic that the shares of hedge funds and banks that invested their money in these securities immediately collapsed. The consequences for most of the investors who had not known how their money was put at risk were devastating.


Even politics has now grown angry over the high priests of the scene. In the US, the highest exchange regulatory body, the SEC (Securities and Exchange Commission) and the public prosecutors of the states of Ohio and New York (where several mammoth pension funds lost an enormous amount of money) have initiated official investigations. The EU commission is annoyed; the EU domestic market commissar threatens "consequences." President Sarkozy wants to scrutinize the operations of the agencies. Good-natured Kurt Beck denounced their "dictatorship" in 2004. European oversight authorities are working on a new mechanism for the finance markets.

Investors and bankers now ask desperately about shifting their billions in losses and immediately cry for the state as in every crisis to socialize their losses to the burden of taxpayers. They should have known whom they blindly trusted. The rating agencies never corrected their rankings on time in any financial crisis of the past 25 years. Even if they had done that, the crises had already broken out. A belated action would have only accelerated a price drop and kindled the panic of investors. When Mexico faced insolvency in 1994, the agencies were as cold as in the Asian crises of 1997. The rating companies first reacted when the financial collapse had already seized the economies of all South East Asia. The same thing happened in the Russian and Brazilian crises of 1998. Three years later in the spectacular crash of the energy conglomerate Enron, the 10th largest US corporation, Standard & Poor's and Moody's still assessed Enron as a debtor of the first grade as it did for years despite obvious balance falsifications. Even four days before the company declared its bankruptcy, both agencies certified its first-rate credit-worthiness (as with Worldcom and Parmalat). In none of these cases did the sages illumine the inscrutable thicket of the markets - despite their supposed objectivity, "mathematical methods" and analytical competence that were always praised.


One reason for the failure was undoubtedly deficient independence. The agencies are paid by the corporations whose products are sounded out. As a rule, the analysts who pass judgment negotiate the royalties with the customers. It is an unwritten law that a good grade must cost banks and investment funds something. The agencies live form their reputation. But their reputation rests on satisfying their patrons that want to do business with the graded securities.

Over 100 years ago in the infancy of the rating business, the investors paid for this service. Today the investment banks and funds put the securities on the market. The supposedly independent auditors often participate directly in the construction of the "financial products" of their clients, particularly in "structured" certified securities and loans. The specialists of agencies design the bundling and packaging of an investment bank's product and grade the constructed security as good money.

Some think rating agencies inevitably take the side of their patrons - to the burden of those who buy these "financial products" in good faith in the objective judgment of the auditors.

Of course the agencies do not accept liability.

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