Downgrading the world's rating agencies

Standard & Poor's downgrading of US government debts from its AAA rating may have turned the world upside down, but I suspect credit rating agencies rarely turn firms inside out. Either way, investors can still lose their pants.

Right after the downgrade, US Treasuries actually rallied after yields fell to their lowest point since early 2009. The market actually deemed treasuries a safer bet after S&P's gaffe, according to New York Times columnist Andrew Ross Sorkin. So much for S&P's credibility.

Oddly enough S&P wasn’t the first to downgrade the US credit rating. Weiss Ratings, Egan-Jones and the mainland- based Dagong also did. The US-based Weiss Ratings in fact challenged the top three agencies to downgrade the United States back in May last year. Weiss gave the country its first C rating (equivalent to a BBB grade by the top three) in April this year but downgraded further in July to C-, just a notch above junk grade. These may not be the most well-known agencies but their early warnings should not have been overlooked.

Individual investors may wonder how credit rating agencies evaluate companies and how bad it can get, if the downgrade of countries provides any guide. After all, the agencies kept their ratings for the doomed Texas-based Enron Corp. even as the mega accounting scandal brewed, keeping the energy giant at investment grade for months, up to just days before it finally declared bankruptcy in December 2001.

Likewise, the top ratings on securitized subprime junk are now seen as the foundation of the entire financial crisis three years ago.

Closer to home in Greater China, Toronto-listed Sino-Forest Corporation was rated investment grade until short-seller Muddy Waters released a scathing report about fraud in early June that led share prices of the mainland commercial plantation operator to plunge 80 percent at one point. A month after the Muddy Waters report, S&P finally downgraded Sino Forest, prompted by significant challenges to its business sustainability following the fraud allegations. Moody's also took similar action later in the month.

So what are the fundamental flaws of the ratings model in which the financial world has seemingly placed its faith?

There is a conflict of interest as debt issuers and not investors select and pay rating agencies to label their bonds. Translate this: "I pay you to evaluate me, and I will provide you with only the information and data I want you to know."

This is common knowledge but it's a pity nothing has been done to change what Warren Buffett publicly admitted to be a flawed system of incentives when he said the ratings agencies should take a meat axe to their business model.

Though the agencies may access other relevant public information, they are less likely to pick up discreet and pivotal information as well as non- documented elements. Hence, they may miss the dirty laundry. Thus the problem we have in our modern global financial world is this: we definitely do need credit rating agencies. They did their homework but perhaps not to the satisfaction of everyone, especially investors.

When things blow up, the companies get re-rated at best. Don’t count on them to spot red flags. A friend and finance industry veteran sums it up nicely: Credit rating agencies are just a tolerable, minimally acceptable level of due diligence but they are not the gold standard.

(Vanson Soo runs an independent business intelligence practice specialized in the Greater China region. This originally appeared in The Standard of Hong Kong e-mail: soovans@gmail.com)