October 11, 2010

Avoid false ratings prophets

Posted in Sunday Business Post · 205 comments ·
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The other night, I watched American Gangster, the marvellous film made about the life of Frank Lucas.

Lucas built a huge heroin dealing network, buying the heroin in Vietnam in bulk and then releasing it on to the streets of New York.

Apparently what distinguished his heroin from the competitors’ heroin was the pureness of the drug.

Unlike his competitors, Lucas had such a good source that he could afford not to cut the drug up so much and therefore the quality of the heroin marked his product out. In an effort to brand his heroin to distinguish it from his competitors, Lucas marked all his heroin bags with the name ‘‘Blue Magic’’.

The Blue Magic mark attested to the premium quality of the drug.

However, to get the premium stamp, Lucas had to employ chemists who would check the quality. It wasn’t good enough to employ addicts to verify, he had to get it properly assessed.

In the real drug world, the drug stamper is a crucial part of the drugs business.

For example, when cocaine comes into Spain from Latin America, Irish dealers, who are buying the drugs from bigger Latin American dealers, will get a ‘‘chemist’’ to verify that the drug is of a certain purity.

Once this quality has been established, the Irish drug dealers will set about moving the drugs from a warehouse in Spain to Ireland.

With the image of drug dealers in your heads, let’s talk about the banking businesses and the various characters who play their role in the money chain.

After all, the credit business, like the drug business, is all about distribution.

The money – like the drugs from Latin America – comes in at the top when the local bank, say AIB, borrows in the money market. In a credit boom once it has the money secured at the top, a bank like AIB goes about pushing the credit through the system so that it can get to the credit junkies at the bottom who will use the credit to feed their consumption habit.

But, like the global drug dealer, the international banking system needs its stamper who attests to the quality of the money or the financial product that is being peddled.

This is where the so-called ‘‘objective’’ ratings agencies come in.

And this is why I get annoyed when I hear some suit from Fitch, Moody’s or Standard & Poor’s prattle on about our credit rating.

Do these people have any credibility?

Like the whole economics and finance industry, the acid test of credibility should be how they answer the simple question: ‘‘Where were you in the boom?”

In Britain in the 1950s the question about personal character was always ‘‘Daddy, where were you in the war?” Now it should be where were you in the boom, and if you were on the wrong side I can’t take you seriously.

So where were the credit rating agencies in the boom? Were they on the right or the wrong side?

Let’s stick with the drugs metaphor to explain where the rating agencies were and what they were doing.

Both investment bankers and drugs brokers need to know the quality of the product they are paying for.

The drugs broker has a chemist. The chemist rates the purity of the consignment, gives it a triple A stamp and takes his fee.

The investment banker’s equivalent of the drugs broker’s chemist is the rating agencies.

By rating companies, banks and countries, the rating agencies should give investors peace of mind – promising them that what they buy is of good quality, unlikely to default and so won’t cause them any sleepless nights.

If the rating system fails or is compromised in any way, the foundation of every transaction collapses.

Consider the drugs world.

What would happen if the chemists were actually paid by the supplier to rate bad stuff as good stuff?

What might the drugs syndicate in Dublin do to a stamper who lied about the quality of the gear because he was in the pay of the supplier?

In the boom, this was not a concern in the banking world. Perhaps nobody ever watched a mafia movie like American Gangster. In the US sub-prime mortgage disaster, the rating agencies were paid by the banks to rate the junk they were selling as triple A.

In reality, some of the assets in this AAA toxic cocktail were worthless. Subprime debt, loans to people who had neither means nor intention of repaying money, were packaged with reliable securities, then given gilt-edged ratings by agencies in the pay of the banks. In the Irish case, our banks – just when they were blowing their balance sheets – were rated AAA by the same rating agencies who are now telling us they can rate us.

Credit was used to buy over-priced houses when there was little connection between the price of the house and its value.

But for this transaction to take place, we too needed a local stamper or verifier.

We needed someone to validate the price paid: ‘‘This is correct.

This two bedroomed terraced house in Monkstown is indeed worth €1million.

Your money is safe here.” This is where the estate agents came in.

They were responsible for valuing houses.

Bizarrely, these valuations were given credence even though, like the rating agencies, an estate agent’s fee was directly related to the sale price.

So house price inflation was in the interests of the estate agents: higher prices meant higher fees.

The banks and the estate agents were hand in glove, working to hoodwink the punters.

Now the same estate agents are telling us that the property market has hit the bottom.

Meanwhile, they have Nama to pay them to value stuff they overvalued in the boom.

And what about the international ‘‘stampers’’, the rating agencies? These lads are the estate agents of the financial world.

They are now on Irish radio telling us how to run our country and what we should and should not do.

They are simply chasing the market. They are always last to know.

Now they are downgrading Irish risk when they should have been downgrading it before the end of the boom, not now when the dogs in the street know what is happening.

Most egregiously, they are given credence.

Next time a Fitch spokesperson downgrades Ireland, let’s just ask him where he was in the boom and then show him the door.

There is one thing I can guarantee: when our fortunes turn, those lads will be the last to cop on.


  1. paulmcd

    FOLKS, WE’VE TURNED ANOTHER CORNER, AND . . .

    I’M GETTING DIZZY

    http://www.independent.ie/business/irish/economy-has-turned-corner-says-top-rating-agency-boss-2376296.html

    Lenny must have been in the US to give S&P a belt of St Patrick’s crozier.

    Mr Beers in Washington, who no doubt has visited ALL the ghost estates, is now “talking up” Ireland – selective amnesia as his agency’s estimate for our bailout cost, 90 billion, is nearly 100% higher than the Government’s 50 billion.

    • The propaganda that hits this country is ridiculous.

      I start to feel sorry for Joe Average who has little chances to looks through all these smoke screens and lies that are fired on us daily.

      It may be one of many explanations why there is no mass demonstrations happening in front of government buildings…. EVERY DAY THAT IS!

  2. uchrisn

    What is the solution to this issue of ratings agencies getting paid by the institution to make their ratings, and obvious conflict of interest? The American government have suggested increasing the number of ratings agencies from the main 3 to 9 or 10 with the aim of mixing things up. However this may just increase the competition to offer a better rating. Any ideas? I know there are not-for profit organisations which have been rating institutions on Enviornmental, Social and Govermenatl factors for decades. For example EIRIS in Europe. Why not give these guys the task.

    • paulmcd

      As far as I am aware, there are boutique agencies which would be specialised in areas of finance, but their information is never made public.

  3. Did anyone else notice the streaming service of Oireachtas to be increasingly unreliable? From skipping transmissions to unable to connect….

    Did anyone succeed using the IPTV stream instead, I guess my ISP does not support it, I can not get that to stream UDP Multicasts.

    • What is to stop any of us on this site to set up a maverick rating agency and include a wider remit of government publications and miscl .

      We could call it : First Chartered

  4. Harper66

    I see plenty comments bemoaning the lack of action or protests on the streets. This mood is probably best summed up by Dorothy Jones – ” Some of the recent demonstrations have been organised by socialist or unfamiliar organisations [to me anyway!], which may discourage many from taking part. If there were ‘apolitical’ background, the irish public would be out on the streets in droves. ”

    I think this gets to the heart of the matter.People would rather leave things as they are than unite under a banner that they feel does not fully represent them. Which leaves me to draw the conclusion we are complicit in all that is going on in Ireland.

    Imagine we would rather leave the corruption and cronyism continue than take part in a socialist march. I have never voted for a socialist party but I would take to the streets with jack the ripper himself if it meant my opposition to this current regime would be noticed.

  5. Tim

    Contributors interested in meeting:

    I have met with wills and our kind Host;
    Furrylugs;(John ALLEN came, but we missed him, somehow.);
    Liam.

    I have had frequent phone contact with PaulOMahonyCork, wills and some with Macholz;

    Online contact with Irishdebate and email with Martinho, Macholz, Malcolm McClure, PaulOMahonyCork, wills, Furrylugs and almost daily contact on Twitter with Constantin Gurdgiev, Our kind Host, Brian Lucey, Michael Taft, wills, LorcanRK, Liam, Furrylugs and occasionally Adamabyss.

    I have also, on a number of occasions, posted my address, home phone number, mobile and email on this site and arranged meeting places/times. I have still only met wills, Furrylugs and David.

    If anyone has an idea that may be more successful than my efforts, I’m all ears (and will go to serious lengths to turn-up!).

    These days, though rather ill, I am easiest to contact at:

    http://www.twitter.com/tnteacherTim

    Feel free to contact.

    We are all circling around, trying to find the best solution. Perhaps, if we all “get into one room” and hammer-it-out, we might find it?

    Best regards to all who are trying, whether we may disagree or not.

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