Ever since this whole sub prime powder keg exploded, I’ve been saying to people that none of this would have happened without the rating agencies. To my surprise, most people have disagreed with me, however, rating agencies appear to be the latest casualties in this expanding crisis (as discussed further here).

So why do I blame the rating agencies? The crux of the argument was eloquently framed in a New York Times Magazine article this week. Essentially, rating agencies “[turned] risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans.” By issuing these independent opinions regarding the relative risk of mortgage-backed securities, the rating agencies facilitated the broad syndication of these products.

To be very blunt, institutions would never have bought these securities without the rating. Investors relied on the rating agencies to conduct due diligence on their behalf and trusted them to do so. In the case of UBS, the highest rated securities were considered so liquid that very little of the highest rated exposure was hedged and it did not appear on many internal reports detailing value at risk calculations (as further described here). We can only assume other financial institutions engage in similar risk weighting practices.

For their part, the rating agencies collected huge fees for issuing such ratings and saw their profits soar. Certain bankers defend the rating agencies by asserting that the relative risk was assessed appropriately given current agreed-upon risk assessment procedures in place. But it would appear that not all Triple-A ratings are made equal. Further, it appears that current rating procedures should be carefully scrutinized and very likely reconsidered.

The rating agencies were not alone in profiting massively. In fact the common factor in this whole sub prime debacle was the money that was made from it at all levels. Mortgage brokers were incentivised by fees to push as many loans through the system as possible. Lenders kept on churning out loans as they knew they could be readily moved off their books; also collecting fees. Investment bankers received huge fees (possibly as much as 6% of the total) for packaging up the mortgage backed securities for onward sale in the market. But this liquidity in the US mortgage market never would have been created without the ratings.

It was like a financial version of musical chairs, except that when the party music stopped, somebody had to hold the sub prime bag. And it certainly wasn’t the rating agencies.

I’ll end this entry with one final thought. Naysayers, including my wife (a former equity researcher), argue that nothing excuses one from not conducting appropriate due diligence. Buyer Beware, it seems. If that is the case, what role do the rating agencies play and why do we trust them anymore anyway?