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When credit rating agencies fail

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Postcard from China

News last month that the Chinese credit rating agency, Dagong Global Credit Rating, had its license suspended is yet another chapter in the less-than-illustrious history of the credit rating industry.

Postcard from China

Irregularities that include giving companies higher credit ratings than their financial standing would otherwise have deserved, in return for cash, are just part of a laundry list of activities Chinese authorities claim to have exposed at the company.

I’m not suggesting for one minute that fraudulent practices such as these are anything other than an isolated incident.  But the fact remains, this is an industry which has struggled with credibility even well before it’s more pervasive practices of assigning triple-A ratings to toxic structured products contributed to the Global Financial Crisis a decade ago.

There is an exhaustive and compelling body of research that documents the many failures of credit rating agencies to fulfil their primary role.  That is, to warn investors of the true risks entailed in the financial assets they rate.

This, in my opinion, is far less about errors in judgement by the men and women conducting the research at these agencies though.  Instead, it is far more about the perverse incentive structure inherent in the industry’s issuer-pays business model. That is to say, when the company you are meant to be critically analysing is the same one paying you for this service, a very clear conflict of interest exists.

When combined with rigid, backward-looking, and often unnecessarily complex rating models it is a constant source of wonder to me how anyone would knowingly rely on credit ratings as a guide to the perceived safety of a fixed income investment. Despite these obvious deficiencies, the investment industry remains wedded to these agencies and their less-than-sufficient ratings.  Be it passive funds that use these ratings to scale portfolio exposures or do-it-yourself investors who don’t have the expertise to assess credit risks themselves, the implications are significant and wide-ranging.    

This is yet another strong reminder that there are no shortcuts in investing.  Ensuring your money is managed by trusted, experienced professionals who conduct thorough, transparent, and independent research is the minimum action you must take to protect your money.

 

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