Mike Shedlock
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Today I am going to do something different, openly praise blatant incompetence. I will list my reasons later but first let me sing the praises of sheer incompetence at Moody's, Fitch, and the S&P (the big 3 rating agencies).

Downgrade of U.S. Debt Long Overdue

Many are in shock that the S&P downgraded debt of the US from AAA. Not me. It was long overdue.

However, the S&P proved it was incompetent in the way it made the downgrade. Pray tell how can a rating agency make a $2 trillion error? The answer is obvious: sheer incompetence.

The irony is Moody's and Fitch proved they are incompetent by not downgrading U.S. debt.

If you need a myriad of reasons, I highly recommend Issues and Solutions for Restoring Credibility to the Credit Rating Agencies and Rehabilitating the Alternative Banking System by Janet M. Tavakoli, President, Tavakoli Structured Finance, Inc.

Also note that Egan-Jones downgraded US debt on July 18 from AAA to AA+ and nobody batted an eye.

"We are taking a negative action not based on the delay in raising the debt ceiling but rather our concern about the high level of debt to GDP in excess of 100% compared to Canada's 35%."

NRSRO Certification

The SEC certifies Egan-Jones as one of 10 NRSROs "Nationally Recognized Statistical Rating Organizations".

The "Big 3" NRSROs are Moody's, Fitch, and the S&P.

Most have never heard of Egan-Jones or any rating agencies but the big 3, and that explains why nobody howled when Egan-Jones did its downgrade, yet everyone howled like rabid wolves over the S&P's action.

The wolves demanded action and action they got.

S&P Under Justice Department Investigation

The Associated Press reports Justice Department investigating Standard and Poor's mortgage securities ratings .

The Justice Department is investigating whether the Standard & Poor's credit ratings agency improperly rated dozens of mortgage securities in the years leading up to the financial crisis, The New York Times reported Wednesday.
S&P Investigated for Insider Trading

The Wall Street Journal reports SEC Asking About Insider Trading at S&P
The post-downgrade backlash against S&P seems to be gathering strength.

The FT is reporting, citing anonymous sources, that the SEC is investigating whether there was any insider trading done by employees of Standard & Poor’s ahead of their downgrade of the US a week ago.

Dow Jones Newswires writes:

"The U.S. Securities and Exchange Commission has asked Standard & Poor’s to disclose who within its ranks knew of the recent decision to downgrade U.S. debt before it was announced, the Financial Times newspaper reported Thursday on its website, citing unnamed people familiar with the matter."

Remember, rumors of a post-bell downgrade were rampant on Wall Street very early on Friday, rumors that turned out to be true. It sure sounded like a leak, though the leak could have come from either S&P or Treasury. It seemed inevitable there would be an investigation, though it could be hard to find anything.

MarketWatch points out that, according to the 2006 Credit Rating Agency Reform Act, S&P could have its license revoked if it leaked word of the downgrade.
Nearly universal sentiment was that treasury yields would rise on a downgrade. I said "no effect". Yields plunged in spite of the downgrade, so clearly the decision had no effect.

Rumors float all the time. The S&P gave a date as to when they would announce. They even hinted at a downgrade in my opinion. So, how tough is it for someone to start a rumor that had a 50% chance of being correct?

Excuse me for asking, but as long as prostitutes are under investigation, what about an investigation of the other two whores, Moody's and Fitch, or better yet all of them for reasons far more serious than unfounded witch-hunts, like outright fraud.

AAA Rated CDOs, CDOs-Squared, and Other Garbage

By now nearly everyone realizes Moody's, Fitch, and the S&P were grossly incompetent and fueled the mortgage crisis by rating pure garbage mortgages in numerous forms as AAA.

But was it gross incompetence or purposeful fraud by the big 3 to see who could collect the most "paying johns", damn the consequences?

Regardless, why is only the S&P under investigation?

The answer is the big three whores are supposed to do what the government says they are supposed to do, and the S&P didn't. So the S&P is under investigation. And that serves as a warning to Moody's and Fitch.

Explanation of Whores

I have used the term "whores" twice now so it needs an explanation. What I mean is the big 3 rating agencies arguably sold themselves to the highest bidder, essentially granting an AAA rating to damn near anything for a fee.

The Rating Agency Model, as it now exists, pays raters on the basis of how much volume they do, not on how well they rate anything. If you are willing to rate pure garbage as AAA no matter what it is really worth, you get a lot more "action" and make a lot more money.

And action the "big 3" got. And everyone, turned a blind eye to the process, because no one likes to end a party, especially a party that whores are throwing with Greenspan and Bernanke cheerleading like a pair of pom-pom girls at the big game.

The SEC Caused this Mess

There is just one more detail I need to point out before we get to the proper solution. That detail pertains to the question "Who Caused this Mess?"

I have talked about this on numerous occasions actually, but perhaps now is the time someone will listen.

Flashback September 28, 2007: Time To Break Up The Credit Rating Cartel
The rating agencies were originally research firms. They were paid by those looking to buy bonds or make loans to a company. If a rating company did poorly it lost business. If it did poorly too often it went out of business.

Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization (NRSRO).

Establishment of the NRSRO did three things (all bad):

  1. It made it extremely difficult to become "nationally recognized" as a rating agency when all debt had to be rated by someone who was already nationally recognized.
  2. In effect it created a nice monopoly for those in the designated group.
  3. It turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn't sell it. Of course this led to shopping around to see who would give the debt the highest rating.

Spotlight on Prostitutes

There is nothing new here. I have been talking about this for years.

But finally rating agencies are in the spotlight of Congress, of foreign governments, of investors, and of pension fund managers stupid enough to buy AAA rated garbage stamped by paid prostitutes.

Solutions

Some of the proposed solutions to this mess are horrific. There is a massive 400 page bill in Congress to address the problem.

Tavakoli's report, cited above, is 50 pages long. I agree with most of her analysis. I cannot endorse the ending paragraph.
The solution is to raise one or more rating agencies up to standard to merit the NRSRO label. Meanwhile, rating agencies can continue to issue ratings but must commit to coming up to standard. Those that cannot should have the privilege of issuing ratings completely revoked. The second part of the solution is to develop global third party benchmarks and global third party rating scales and make accurate ratings the only measurement of success.
No, that is NOT the Solution

The government does not have and never has had a need to have a NRSRO label. Moreover, there is no need to require all debt be rated. Indeed, the act of mandating that all debt be rated by designated rating agencies is what led to the escalating problem of everything being rated AAA in the first place.

Finally, it is complete silliness to suggest some committee can determine who merits NRSRO and to wait until rating agencies come up to standard.

THE Solution

  1. End immediately the NRSRO label. Neither the government nor the SEC has any business handing a monopoly business to anyone.
  2. End immediately the requirement that all debt be rated. The market will sort this out in a flash.
By immediately I mean 6 months, 8 months or whatever time is appropriate for debt-buyers to decide who they want to use as opposed to some committee deciding who should be approved.

People buying debt will have to do homework, but that is far better than trusting an AAA rating placed on garbage by prostitutes paid to place a label.

Over time, Moody's, Fitch, and the S&P will do a better job, or they will cease to exist. Simply put, those who rate debt accurately will flourish, those who don't will go out of business.

What's wrong with that?

So Why Do I Praise Blatant Incompetence?

I praise blatant, timely incompetence because it takes massive force (in this case universally recognized blatant incompetence at precisely the right time), before there is any chance of getting change.

There is a small window of opportunity here.

The time to take advantage is now. Instead of silly Congressional investigations of the S&P in regards to the timing of their announcement, Congress simply needs to write a bill eliminating the NRSRO label and the requirement that debt be rated. Yes, it's as simple as that.

S&P, I salute your gross incompetence. Your timing was perfect. Whether anything sensible happens remains to be seen, but at least there is a small chance for reasonable voices to be heard.

Contact Congress

Please send your congressional representatives an email or fax and tell them to scrap the NRSRO "Nationally Recognized Statistical Rating Organizations" rating entirely, ending the monopoly of Moody's, Fitch, and the S&P.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike Shedlock

Mike Shedlock is a registered investment advisor representative for Sitka Pacific Capital Management.