Who let the dogs out?

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: as equity markets (grading IPOs, for example). But more importantly, ratings operate in an oligopolistic market, with too many issuers chasing too few rating agencies. Consequently, some of the ratings themselves are debatable.

In the context of the subprime crisis, international rating agencies have been roundly criticised for their indirect role in accentuating it, with some of the reports harping on an apparent conflict of interest: “Mortgage securities involved are largely based on mortgages sold by lenders to investment banks. The private rating organisations are paid large fees by the issuers of these securities to issue their ratings.”

Without even going into the conflict, rating agencies have much to answer for. When a bank creates mortgage-backed securities, it discusses with these agencies the quality of the debt contents therein, including subprime debt, before slicing up the security into several pieces in order to get the desired rating for each portion. Even if we assume that this did not happen, the agencies failed with their due diligence. Remember the age-old proverb, “One bad apple spoils the barrel”? Even if there was a single subprime borrower, the entire security should have been rated as non-investment grade.

There is another aspect to this. Since these securities are backed by assets, in common parlance, rating agencies consistently rated these mortgaged-back securities as “investment grade”, meaning they were seen as carrying low risk. With the onset of the subprime crisis, some of the papers earlier rated as AAA have now being downgraded. Interestingly, the downgrading of AAA-rated papers reminds me of a typical problem in India. My analysis shows that a majority of the rated securities that defaulted over the studied period in the Indian market were initially rated by Indian rating agencies as AAA. Rating agencies will say they had downgraded these papers before their default. However, the fact is that these agencies failed to anticipate it in the first place.