STAFF NEWS & ANALYSIS
What Jules Kroll Is Not Saying About Ratings Agencies
By Staff News & Analysis - August 21, 2012

Time and again, the traditional agencies' analyses have lacked any foresight, even after the lessons of the subprime mortgage debacle. It's hard to trust companies that have repeatedly gotten it so wrong. A year after S&P downgraded long-term U.S. Treasuries, investors are still buying them up, and little else has changed: Interest rates remain low, and Dow Jones industrials are high. Then, take Greece. In 2009, Moody's said that fears about Greece's financing were "misplaced," according to the New York Times, only to go on to downgrade Greece's debt. We all know the fallout from that. These were the same firms that gave Enron an "investment grade" rating back in 2001, just before it filed for bankruptcy. And lest you've forgotten by now, they also gave Lehman Brothers a favorable rating before its collapse. – Reuters

Dominant Social Theme: What American ratings agencies need is transparency, accountability and more numerative substance.

Free-Market Analysis: Jules Kroll is back in town. The man, who is really a myth, single-handedly invented private, white collar, corporate investigations. Now he wants to reinvent the US ratings agency industry.

Standard and Poor's, Moody's and Fitch Ratings ran into trouble after the earthshattering financial crash of 2008. All three were busily providing ratings for lots of money right up until the West's economy virtually shattered overnight.

In fact, there really wasn't much the big three could do or say. Unlike many other market participants, their job was uniquely focused on predicting risk and, given what occurred, it probably wasn't possible to formulate an adequate defense.

They've been trying to brazen it out ever since but one assumes their position is eroding. Brussels is beginning to investigate whether the agencies have the resources and plain competence to evaluate risk. This is actually a fair question to ask.

But beyond this, the agencies are in a bind because their business is essentially an artful one. It deals with a gray area that goes well beyond the numbers. And as such, the agencies are lightening rods for resentment and irritation. A downgrade costs money and can kill a business deal.

When the agencies were seen as in a sense infallible, such power was granted simply because the agencies acted like a force of nature. They existed, and there was no real recourse.

But now, given that virtually every entity large or small in the Western world would have probably unraveled without what is by now US$50 TRILLION in loans and outright giveaways by the world's central banks, there isn't much of a defense to muster.

Kroll is right to perceive a new business opportunity, given the fundamental injury the business has received. What is less clear is why Kroll believes he has invented a better mousetrap.

He is, nonetheless, and in this Reuters editorial he explains it. But first, a little more about the man – who would be a formidable entrant in any industry. Here, from Wikipedia:

Jules B. Kroll invented the modern corporate investigations industry when he founded Kroll, Inc. in 1972. Kroll Inc. was ultimately sold to Marsh & McClennan Companies for $1.9b in 2004. In 2009, Kroll founded two successor firms, Kroll Bond Rating Agency and K2 Intelligence. KBRA is the first independent bond rating agency formed since the credit crisis in 2008.

Kroll intends to offer "clear and transparent" ratings and to restore "trust" in an industry badly in need of some. In the editorial, which is engagingly part opinion and part promotion, Kroll lays out the problem that the current crop of US ratings agencies have and then proposes his solution. Here's how he positions it:

Credit rating agencies should adopt a new business model that includes transparency, accountability and strong analytics as its cornerstones. When my firm employed this model, our average report produced anywhere from 30 to 50 percent more content than a firm like Moody's. We are able to routinely provide timely, forward-looking research so investors and the public can make more informed decisions. If a rating turns out to be wrong, we will say so.

This new approach will work. Markets don't trust the old model, not just because it's been wrong so often but also because it is conducted in a vacuum. Traditional rating agencies go into a back room and come out with a letter grade that increasingly appears to be chosen out of thin air. But a model that includes full and public disclosure of the methodology used to reach the rating, and long-term accountability for whether the rating was right or wrong, will restore confidence. It won't happen overnight, but little by little, it will happen.

With due respect to Mr. Kroll, who's been extraordinarily successful, this strikes us as a somewhat simplistic approach to resuscitating the ratings business.

He does make good points in the editorial about the persistent problems that the big three US agencies face. Interestingly, he uses the market itself as his touchstone, pointing out that the agencies are becoming irrelevant not because they are right or wrong but because investors aren't listening anymore.

After Moody's downgraded the ratings of 15 global banks, he explains, US bank stocks actually went up. "When the sovereign debt of Germany, the Netherlands and Luxembourg were downgraded on July 23, U.S. stocks remained largely unchanged."

Just look at the US Treasury bond market following Standard & Poor's downgrade of the United States: "Investors are making key investment decisions using their own analysis."

Horrors!

From our point of view (admittedly not Kroll's), the problems that the ratings agencies face simply stem from their unwillingness to adopt an Austrian, free-market economic model.

It would be interesting to press the agencies on the economic model they DO follow. Probably you'd get the old runaround. You'd be told that your rating was linked to your financial position, business prospects, etc. But if you persisted in asking them how they DEFINED the money they're evaluating, you'd probably get nowhere fast.

Even Kroll doesn't get into it. He talks about a deeper level of evaluation but we'd bet this merely entails more number-crunching and more "transparency."

Ask Kroll whether there is a danger in government printing too much money and he might say yes. Ask him how much is too much, and if he's telling the truth he'd have to admit that he doesn't know. The ratings agency business, in the end, is "smoke and mirrors." It was issuing healthy ratings to bankrupt businesses and country's right up to the collapse.

Kroll's idea that more intensive statistical analysis will make a difference doesn't address the fundamental problem at all. The problem has to do with monopoly fiat central banking. Until the agencies, Kroll's included, are willing to forthrightly state that every ten years or so excessive money printing will cause a crash and drive numerous firms out of business, their models will be flawed.

But it will never happen because we live in an era of faux-economics. The power elite that has set up this mad and miserable system intends for it to do exactly what it's done. Those at the top could care less about the current ratings system or those agencies that purvey it. Not really.

Kroll ends this way:

The solution is not to banish credit ratings to the scrap heap of history. Nor to eliminate an important tool for valuing debt and keeping capital markets solvent. What we really need is a new model to restore credibility to the industry once again. Put simply, ratings are too important to not be trusted.

Credit rating agencies can offer an important assessment of public-sector institutions, the structured finance sector and other market conditions more broadly. When these analyses are conducted thoroughly and independently, they are valuable. For example, if demand for a state's general obligation bonds – which credit agencies rate – exceeds the bonds available, a state can reduce interest rates and potentially save millions over the life of the bonds.

After Thoughts

God help us.

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