By Martin Hutchinson
There's a new name in the credit-rating-agency business these days: It's Dagong Global Credit Rating Co. Ltd., and this Beijing-backed business is China's bid for a spot in the global-credit-rating oligopoly.

And Dagong's Chairman Guan Jianzhong doesn't think much of his long-established U.S. competitors.

"The Western rating agencies are politicized and highly ideological and they do not adhere to objective standards," Jianzhong told The Financial Times earlier this month.

Is he right? And does the newly passed Wall Street Reform and Consumer Protection Act correct their flaws, or does it make matters worse? It's a question that affects all investors - even those of us that don't invest in bonds, as we'll soon see.

The credit-rating-agency system we have today grew up in the 19th Century. It was supposed to provide a way for bond investors to get information about credit quality of the corporate bonds they held or were interested in buying or selling - a bit of data that was very hard to get in those days, given the almost invisible standards of disclosure.

As regulators took over such industries as the insurance sector following the Great Depression, it appeared to make sense to use credit ratings as investment guidelines for the insurance companies' bond portfolios. When securitization came along after 1980, credit-rating agencies were naturally used to provide assurances about the underlying pools of assets that investors had no hope of assessing independently.

With corporate debt, the credit-rating system worked reasonably well.

The rating agencies were paid by the issuer, which was theoretically a conflict of interest. However, investors were protected by the fact that the rating agencies needed to preserve their reputations: If too many AAA-rated companies went belly-up, the rating-agency system would have fallen into disrepute.

Internationally, there were always problems.

Just take Venezuela. For decades, the rating agencies - blinded by the beauty of that country's oil reserves - rated Venezuela as a AAA investment. We saw how badly that ended.

Domestically the system worked pretty well. The rating agencies got pretty good at corporate credit assessment, preserving themselves from trial lawyers by stating firmly that they were only expressing an opinion on the value and quality of securities - like journalists, really.

Securitization: The Credit Rating Wildcard
The problem arose with securitization. It is now clear that neither the originating banks nor the rating agencies really understood securitization credit risk. They took a portfolio of assets being securitized, looked at historical default rates and applied so-called"binominal distribution analysis" to calculate the probability of the bonds defaulting.

If the portfolio consisted only of prime home mortgages, this approach wasn't all that inaccurate.

Post your comment  (0)

Connect:

Post to Twitter

Post to Facebook