Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [62]
Statistics is the mathematical study of the probability and likelihood of events. Known information can be taken into account, and likelihoods and probabilities are inferred by taking a statistical sampling.The designation sounds impressive, but the rating agencies do not live up to it.
The rating agencies problems run deep. In late 2003, the Financial Times took rating agencies to task for misrating debt issued by scandal-ridden Parmalat, Enron, and WorldCom. Fitch protested that “credit ratings bring greater transparency.”8 Standard & Poor’s retorted that “rating agencies are not auditors or investigators and are not empowered or able to unearth fraud.”9
I responded that investors would be foolish to believe rating agencies provide greater transparency for structured financial products. In fact, the opposite is true. Investors relying on ratings to indicate structured products’ performance are consistently disappointed in a variety of securitizations. S&P downgraded Hollywood Funding’s deals backed by movie receipts from AAA, the highest credit rating possible, to BB, a noninvestment grade rating. Bond insurers raised fraud as a defense against payment, and S&P had thought payment was unconditional.10
Warren does not rely on the rating agencies since his fundamental analysis of a business’s value is superior to anything the rating agencies are doing. If you understand the value of a business, you do not need to rely on a rating agency.
If everyone followed this guideline, the global credit meltdown could have been avoided. In fact, the rating agencies had warning of the need for change through a series of similar mishaps in the past. In 1998, they downgraded around $2 billion in securitizations backed by charged-off credit card receivables managed by Commercial Financial Services. Ratings went from investment grade to junk overnight. Rating agency failures cropped up again in subsequent years with respect to securitizations by Parmalat, manufactured housing loans, metals receivables, furniture receivables, subprime, and more.
When rating agencies make mistakes in securitizations backed by debt, the losses tend to be permanent and unfixable. The sole source of income is the portfolio of assets. If you fail to understand the risk of the assets, you have blown the entire job.
Unlike Warren, the rating agencies failed to drill down and examine whether the assets could generate the cash to pay back investors.
Rating agencies correctly point out that deal sponsors and investment bank underwriters are responsible for due diligence. Although the rating agencies do not perform due diligence for investors, they can demand evidence that proper due diligence has been performed before attempting to apply their respective ratings methodologies. In fact, it is not possible to perform a sound statistical analysis without it.
In the mortgage loan securitization market, a statistical sampling of the underlying mortgage loans should verify: integrity of the documentation, the identity of the borrower, the appraisal of the property, the borrower’s ability to repay the loan, and so on. Rating agencies should take reasonable steps to understand the character of the risk they are modeling.Yet, they seemingly rated risky deals without demanding evidence of thorough due diligence.
When rating agencies use old data for obviously new risks, it is financial astrology. When rating agencies guess at AAA ratings (without the data to back it up), it is financial alchemy.When rating agencies evaluate no-name CDO managers without asking for thorough background checks, it is financial phrenology. In other words, the rating agencies practice junk science.The result is that junk sometimes gets a AAA rating.
Since the rating agencies are effectively a cartel, investors do not have an alternative to this flawed system other than to do their own fundamental