Rating Agencies: Can You Trust Your Financial Institutions and the Companies that Rate Them?

“The truly scary thing about undiscovered lies is that they have a greater capacity to diminish us than exposed ones. ”
-Cheryl Hughes, professor of philosophy and ethics

Financial institutions love to boast their AAA, AA, A2 and A+ ratings. But just like the grades of students disciplined for cheating on tests, those impressive scores may not mean what they’re supposed to.

One of many startling facts presented in Charles Ferguson’s Academy Award winning documentary on the subprime meltdown, Inside Job, was that AIG and Lehman Brothers maintained nearly-perfect ratings from the three big rating agencies until days before bankruptcy. This clip from Inside Job, described by one reviewer as a “Wall Street horror film,” gives further details:

In an interview with Katie Couric, asks Ferguson, “Why do large banks pension funds still trust the rating agencies – why does the government insure… banks that trust them… when all these companies that failed had pretty good, strong credit ratings from big companies like Moody’s and Standard and Poor?”

Ferguson’s response is revealing:

Money had a great deal to do with it… Rating agencies are actually extraordinarily powerful, much more so than people realize, and they get paid by the issuers of securities, so when Goldman Sachs was getting ready to sell a security, it would pay a rating agency to give it a rating, and what a ‘surprise’ if that turned out to be a good rating.

Those same rating agencies also rate the investment banks themselves, and – here’s where their political power comes in – they also rate government securities.
So it’s actually very, very dangerous to cross a rating agency.

Rating agencies took heat in the subprime crisis, first for high ratings that failed to diagnose the ills of failing banks, then for subsequent downgrades that wreaked further havoc across markets and firms, sealing fates when panic ensued. But shockingly, as this article in the Huffington Post reveals, not a single analyst at the rating agencies who gave positive ratings to AIG and Lehman Brothers had fired or disciplined in the aftermath of the debacle.

So, what’s an investor to do?

Have things improved? Are rating agencies any more reliable today? While they seem less likely to slap a triple A on any company, country or investment product that hasn’t defaulted, rating agencies are still a poor crystal ball.

Pressed by the UK’s Treasury Select Committee earlier this year, Dominic Crawley, head of Standard & Poor’s financial services ratings admitted, “Ratings are opinions… we do not expect an individual investor, or at the other end of the spectrum, a sophisticated asset manager, to rely solely on what we provide.”

So how do you know who to trust? Ah, the point exactly!

1. We’ve got to stop pretending that Wall Street is looking out for us.

Just because your financial planner is honest and well-intentioned doesn’t mean that the market is safe, stable, or sane place to invest your money. We have to wise up and realize that Wall Street is nothing more than sophisticated, socially-accepted gambling, a Vegas Casino in a New York designer suit.

And the odds have changed. From the repeal of Glass-Steagall, which separated commercial from investment banking for seven decades, to the advent of high-frequency trading (both, incidentally, in 1999), investors are exposed to greater risks than ever before.

If you or your broker have the time, skill, interest and talent to turn a profit in the market (and you can afford to take potential losses), then go right ahead. If not, perhaps it’s time to stop expecting Wall Street dogs to guard the investment hens you’re counting on for your golden nest eggs.

2. Understand what real diversification actually means, and practice it.

Diversification is not having some of your portfolio in blue-ship stocks, some in small-caps, some in tech stocks, some in healthcare, and other stocks in international development. Diversification is not having five 401k’s or IRA’s managed by five different financial planners. Diversification is not even dividing up your investments between stocks, bonds, and mutual funds.

Diversification is having rental properties, whole life insurance policies, self-directed IRA’s, and ownership of businesses. Diversification means limiting your exposure to the market – perhaps up to the point where your 401k is “matched” by your employer, perhaps down to 0.

3. Financial institutions are not created equally… so choose wisely.

There is a qualitative difference between a credit union, a community bank, and a large commercial bank. In a nutshell, the bigger the bank, the bigger the bailout. In an analysis of locally rooted banks, Marjorie Kelly writes,

At a time when mega-banks were receiving billions in bailouts, the vast majority of credit unions needed none. These customer-owned banks remained financially sound because they were conservative lenders, generally holding onto loans rather than selling them off… they had built-in incentives to care whether loans would be repaid.

Likewise, there is a world of difference between stock and mutual insurance companies. Stock companies are traded on Wall Street, and have shareholders who they must keep happy with profits and dividends. A mutual company operates more like a co-op or a credit union; it’s members are it’s shareholders.

And should you wish to compare credit ratings while choosing an institution, check out Weiss Research.  Generally acknowledged as the toughest of the rating agencies, they are independent and known for challenging Moody’s, Fitch and S & P to lower their ratings, for instance, on the U.S. debt.

Is There an Alternative to Wall Street?

While there’s no doubt that Wall Street investment banks, credit rating agencies, and subprime lenders were major players in the financial crisis, there’s another side to the story. The meltdown was also made possible by our own collective choices as consumers. Perhaps, instead of trying to “occupy” Wall Street, we need to boycott it instead.

Stay tuned for next week’s post, we’ll be making an exciting announcement about a new book that will show you how to take control of your own money and do just that! Or you can get the details now in this juicy interview on “Busting Financial Planning Lies” between No BS Money Guy Todd Strobel and Partner for Prosperity’s Kim Butler on the Guide to Financial Peace radio show.