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