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I would like to introduce a new friend of mine and guest writer to Frugal Franco who goes by Macro Marco. As his name suggests, he is all about macro economics and has written the following article to explain the role credit rating agencies play in the market.

Franco

Many investors are feeling the pain of being left with close to nothing after putting their money in previously believed to be “safe” investments. They feel betrayed, lied to, and cheated. After all, they were told by the credit rating agencies (CRA) that their investment was of the highest grade possible with only an infinitesimally small chance of ever losing money. So what went wrong? Are the CRAs broken?

Let me talk to my manager and see what I can do

Paralleling used car markets with debt markets can on the surface appear inappropriate and misguided. But, the ambiguity of pricing used cars bares a striking resemblance to valuing today’s complex structured products.

When the time comes for our cars to move on to a better place, some of us may find ourselves wondering the rows of a used car lot. For the sake of example, let’s assume there are only two types of cars to buy — peaches and lemons. Peaches have a true value of $10,000 while lemons have a true value of only $5,000. Further, assume that only sellers of the used cars know any car’s true value while buyers are left to use their best “guesstimation” – which may be as scientific as following the flight patterns of airborne grass blades. Because buyers cannot know the true value of any particular car, the rational buyer will only be willing to pay the average of a peach and lemon — $7,500. Meanwhile, sellers know the true value of every car on the lot and their price in relation to the buyer’s mean bid. Not willing to take a realized loss, sellers will not sell peaches, but instead flood the market with only lemons. Once this happens, rational buyers will catch on to the seller’s tricks and readjust their bids or abandon the market all together.

Clarity now!

The apprehensive nature of buyers in this market is due to the fact that we struggle to know the quality and history of any car in the lot. More broadly, buyers suffer from the inability to correctly identify a good car (peach) from a bad car (lemon). The lemon in the used car market exemplifies the problem of what is known as adverse selection – when one party holds information that is not shared with the counterparty. Due to their association with adverse selection, used car markets have developed poor reputations and struggled to realize liquidity. Enter, Kelley Blue Book. To those unfamiliar, Kelley Blue Book serves as the price-governing body of the used car market. Using blue book values, buyers can quickly find true market values of any make or model with a given amount of miles, additional features, and after market whistle tip upgrades. When buyers receive price enlightenment, liquidity flows and the market finds equilibrium.

As debt offerings in the financial market are to cars in the used car market, credit rating agencies are to Kelley Blue Book. To have a well-oiled market, price and risk discovery supplied by CRAs must be present. Investors will not hold debt without knowing true default risk and appropriate return (yield) for taking on such risk. CRAs are instrumental in providing such insight.

The smoking gun

So what went wrong? The smoking gun may be the incentive structure in the rating industry. As Franco recently touched upon, many players motives were more closely aligned with quantity rather than quality and credit rating agencies were no exception. In the shadow of the financial crisis, the reputation of CRAs has fallen under a scrupulous eye. Much of the debt that is defaulting had previously been given the highest possible marks. If the fallout continues on Wall Street, more banks will fail, markets will stagnate, and jobs will be lost. This devastation, which formerly bore the probability of close to zero, will cause more defaults in the debt market leaving investors shell shocked and CRAs with “egg on their face.”

The credit rating agencies are ailing and may never recover from the blow to their reputation. Only time will tell what will become of this industry. Perhaps the rating agencies need a rating themselves.

Bona sera,

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