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Ratings Agencies Are Ruining the World: Macke

Fin - Breakout - US

Earlier this week Moody's downgraded Portuguese bonds four full notches, all the way to "junk" status. The move sent yields and the cost of insuring EU debt against default soaring. The downgrade also put European officials into a rage as the motivation and competence of Moody's (MCO), Fitch, and Standard & Poors were openly questioned.

The working theory in the EU seems to be that American patriotism played a role in Moody's actions. European Commission President Jose Manuel Barroso noted, "it seems strange that there is not a single rating agency coming from Europe. It shows there may be some bias in the markets when it comes to the evaluation of the specific issues of Europe."

European Central Bank President Jean- Claude Trichet essentially plugged his ears and ignored Moody's entirely. Trichet says the ECB will suspend the minimum credit-rating threshold on Portuguese bonds "until further notice". The move is significant in that it neutralizes the cornerstone of the rating agencies' power by disregarding the ability of the agencies to impact Portugal's cost of capital. Ratings downgrades typically lead to automatic investment decisions by investors. Bond holders mandated to only hold investment grade securities would now be forced to sell, or at least not buy Portuguese debt unless they adopt Trichet's policy.

Going a step further than the ECB, EU officials say the "oligopoly" of the Big Three has to be disbanded. Openly skeptical of the downgrade's timing and magnitude in the face of delicate negotiations between European banks and Greece in efforts to avoid an official Greek debt default, Barroso used strangely refreshing sarcasm: "With all due respect to that specific ratings agency, our institutions know more about Portugal a little bit better."

Mr. Barroso is on safe ground with the last assertion. Based on what Moody's et al understood about mortgage-backed securities, CDOs, and the rest of the garbage products whose high credit ratings catalyzed the entire financial meltdown, the average Portuguese water dog understands more about Portugal than Moody's does.

Debt downgrades are self-fulfilling prophecies. Lowering Portugal to junk increases the nation's cost of capital. When the cost of capital goes higher the odds of continued solvency move lower. Any of the EU's PIIGS (Portugal, Italy, Ireland, Greece, Spain) could be categorized as a credit risk. That said, Moody's 4-notch downgrade amid Greek debt negotiations pours gas on a growing economic fire in the EU.

The opinions of the Big Three ratings agencies continue to matter because their views codified into debt investment mandates. Imagine giving three investment banks the power to determine the largest equity portfolios in the world. While it's unthinkable to suggest some Goldman analyst's downgrade would force mutual funds to dump a stock that's exactly the power wielded by Moody's, Fitch and S&P in the debt market. Fidelity can hold a stock rated "hold", debt funds often have to dump anything rated "junk". The Big Three justify this power by claiming they're protected by the First Amendment. Hate speech is more tightly regulated than the Moody's right to plunge Portugal into financial ruin.

I'm a fan of the First Amendment; just not when it applies to oligopolies. Exercising my own right to Free Speech: Moody's, Fitch and Standard & Poors were the enablers of the financial malfeasance. There's plenty of blame to go around but the vast majority is directed at "big wigs", "bankers" and the mortgage company CEOs. These are the guys vilified in Senate Sub-committees and movies like Inside Job. The business of ratings is perhaps the only institution involved in the meltdown allowed to continue operating just as they did in the years leading up to the crisis.

Management at the ratings agencies is either criminal or criminally inept. Organizational stupidity knows no borders but it can be controlled. Whatever you think of the ECB or Jean-Claude Trichet the man is right. It's long-past time for central banks as well as institutional and private investors to start entirely ignoring the opinions of the ratings agencies.

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