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When Trustees Fail

Omkar Goswami

Societies survive, grow and prosper on trust. And fail miserably when trust breaks down between people, communities, groups and institutions. What is true for societies is equally valid for markets. A Rs.100 note is just a piece of officially printed, serially numbered paper issued by the Reserve Bank which promises to pay the bearer the sum of one hundred rupees. It isn’t backed by any precious metal. Indeed, after 15 August 1971 when the US shut its gold window based on a fixed exchange rate of 35 troy ounces of gold, no currency in the world is backed by anything other than the guarantee of its central bank — hence by trust in the government and its major financial institution.

We accept the Rs.100 note because we have the trust that anyone else in India will also accept it. If we didn’t, the market economy would degenerate to pure barter. It is most often seen in periods of acute hyperinflation, such as the one ravaging Zimbabwe. At an inflation rate of several million per cent per annum, people won’t accept currency. It has become a fear stricken, utterly inefficient barter economy.

The trust in market economies have much to do with the quality, ability and the respect commanded by the key trustees. There are many. Efficacy of the monetary and banking system depends upon the trust that we have on the central bank and banking regulators. Capital market regulators are critical to ensure a level playing field, transparent transactions, smooth clearing and settlement in the stock exchanges, and protection of minority investors’ rights. Insurance regulators must ensure that the monies which companies garner from individuals and corporates for long term protection are not obtained through misleading promises and are deployed in a sufficiently safe manner.

This brings me to debt and the role of global credit rating agencies such as Moody’s, Standard and Poor’s, Dun and Bradstreet, Fitch and some others. Unlike equity which need not be serviced in bad states, debt has to be, irrespective of whether the originator is doing well or poorly. It, therefore, becomes critical for any potential buyer of any debt paper to get an impartial, ‘true and fair’ independent assessment of the entity’s capability of service the debt. Thus the genesis of the so-called independent credit rating agencies. And ever since debt paper — sovereign, state governments, municipalities, companies or others — began to be appraised by these agencies, the ratings determined the risk, and hence the price and cost, of investing in any such instruments. High ratings allowed the issuer to get a good price for their paper. Poor ratings sharply lowered the price. We bought or didn’t buy based on the trust that we bestowed on the rating agencies.

Today, everyone will agree that these key fiduciaries have abjectly failed in discharging their trust to the global investing community. The only ones who think differently are the bosses and employees of the rating agencies.

Consider their disreputable role in the sub-prime crisis, especially in their rating of mortgage backed collateral debt obligations (CDOs). Well over $1.5 trillion of high risk sub-prime mortgages were originated in the US between 2004 and end-2007. If you added to this marginally lower risk below prime mortgages, the amount will total over $3 trillion. These mortgages were aggregated, sliced, diced, window dressed in every conceivable manner to create myriad portfolios of CDOs which, after a few iterations and re-slicing, had no clear relationship to the real underlying assets. Each rating agency assigned fairly attractive ratings to most of these securities based on arcane mathematical models that few knew anything about. Armed with good ratings, these rubbish pieces of paper were sold everywhere — pension funds, private equity firms, municipal treasuries, sovereign funds, mutual funds, and the rest. No buyer knew the quality of what they were purchasing. They bought on the trust and faith they reposed on the rating agencies.

We now know it now that these great fiduciary bodies were self serving creatures who, in order to get the business from the issuers of such CDOs, always found an appropriate ‘mathematical model’ to pronounce an attractive enough rating. The denouement: financial meltdown, panic, liquidity gummed up everywhere, the complete lack of trust between financial intermediaries and write-downs that will eventually tot up to well over $2 trillion dollars before the blood is swabbed off the street.

Why? Because the trustees failed in doing what they were supposed to do. As Anderson did with Enron. Only this time the impact is several thousand times more. Will the CEOs of these rating agencies be taken to task? I think not.

My initial thought of this article’s title was “Hang ‘Em High”. But that would be too much like a lynch mob. Though I would be sympathetic to that as well.

Published: Business Standard, October 2008


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