The bad behavior of the credit ratings agencies was a root cause of the global financial crisis. As TV pundit Charlie Gasparino put it, they have “the most corrupt business model in corporate America.”
The “big three” credit ratings houses – Moody’s, Fitch and S&P – have a special mandate from the government. They alone have official sanction to determine the creditworthiness of an investable debt instrument.
This mandate equates to a highly profitable monopoly because many bond buyers – pension funds, institutional houses and the like – can only purchase “investment grade” debt. And the only ones that can officiallydetermine a debt issue to be “investment grade” are Moody’s, Fitch and S&P.
So how did this contribute to the global financial crisis? Simple. The credit ratings agencies threw due diligence out the window in order to gorge on profit. They went around stamping “triple A” on garbage bags full of subprime crap because they were paid handsome fees to do so. (Ratings analysts who felt unsure about this course of action were pressured to either shut up or find another job.)
At the height of the housing bubble, it was the credit ratings agencies that performed the seeming magic trick of turning investment bank garbage into gold. Without their rubber stamp, investors would not have had an excuse to gorge on the supposedly safe “triple A” securities that were, in reality, radioactive toxic waste.
Not only did the credit ratings agencies fail utterly in their one important job – determining the risk of an investable debt instrument – they topped it off with an uncanny knack for making every debt crisis worse. Here is the formula the big three inevitably followed:
First, keep an investment grade rating on a company (or a country) for far too long.
Second, completely ignore the mounting danger signs as the debt situation deteriorates.
Third, wait until the most useless moment to act (after the crisis is already in full bloom).
Fourth, issue a “downgrade” at the worst possible moment, making the whole situation implode.
The ratings agencies are so big, dumb and dangerous it is hard to fathom. Their “stamps of approval” are useless, except in providing government-mandated cover to lethargic investors too lazy to do their own homework. And rating downgrades generally come at the worst time… far too late to actually be useful, except as a sort of collapse-inducing doomsday device with fear and panic already mounting.
The credit ratings agencies are only in business because of the government. They are the culmination of a dumb idea, brought to full bloom with catastrophic consequences.
And yet, Warren Buffett seems to think the credit ratings agencies are wonderful. Just like Goldman Sachs.
A Rich Irony
Last week, Warren Buffett appeared before a special panel, the Financial Crisis Inquiry Commission, by order of government subpoena. The Oracle of Omaha was required to testify as a major shareholder of Moody’s (MCO:NYSE), one of the big three ratings agencies.
It was a sad spectacle. Buffett trashed his own reputation by way of his poor defense of Moody’s, and made himself look naïve and incompetent in the process.
This is the second post-crisis episode in which Buffett has flushed a large chunk of reputational capital down the toilet. The first was when he decided to vocally defend Goldman Sachs (or rather, his billion stake in Goldman Sachs) in light of actions that were illegal at worst and shockingly sleazy at best.
Many times over the years, Buffett has referred to derivatives as “weapons of mass destruction.” He has also expounded repeatedly and at length on the virtues of reputation, honesty and fair dealing.
So it is truly a rich irony that, if one were to draw up a list of derivative-wielding “mass destruction” finalists whose actions directly facilitated the global financial crisis, Goldman Sachs and Moody’s – the very entities Buffett now chooses to defend – would have space near the top.
It would be one thing if Buffett were just another amoral capitalist. No one particularly notices when, say, the CEO of a large investment bank wriggles around uncomfortably like a worm on a hook.
But Buffett was supposed to be different. He was supposed to be the folksy everyman investor writ large… the down home investor’s ambassador of hamburgers and Cherry Coke and mom and apple pie.
After years of cultivating an aw shucks, “Uncle Warren” persona, seeing the truth for what it is feels like a Hall of Fame baseball player admitting to steroid use. The hero was artificial… the persona was fake… and the letdown is sad.
(By the way, Buffet may be in the news, but he’s not the only thing moving the market right now. If you’re looking for additional market analysis, sign up to read fellow editor Adam Lass’investment commentary.)
Can’t Afford It
Something else to consider: You may have heard a time or two (or three) that it would be prudent to invest like Warren Buffett.
With all due respect, you might want to forget that advice. Why? Because unless you’re a billionaire, you probably can’t afford it.
As of last week, Buffett’s Berkshire Hathaway was still a majority shareholder in Moody’s with roughly 13% of the company (down from a stake of more than 20%).
I don’t know about you, but I’m certainly not rich enough to hold onto investments as they decline seventy percent in value. Buy and hold might sound good in theory – but then so does the halfwit observation that “eventually, the market always comes back.”
There is a time to buy and a time to sell, even for the longest of long-term investors. One would think that’s a hard point to overlook.
At the hearing last week, Buffett’s excuse for Moody’s, and for himself, was that he missed the housing bubble completely. “There was the greatest bubble I’ve ever seen in my life … Very, very few people could appreciate the bubble and that’s the nature of bubbles,” Buffett said.
Apparently Buffett couldn’t appreciate the bubble either… even though he has been investing for six decades, has lived through all manner of bubbles, and reads multiple newspapers every single day.
The big ratings agencies “made a mistake that virtually everybody in the country made,” Buffett lamely added to his and Moody’s defense. As if there were no warning signs, no table pounding, no vocal cries of concern. (In truth there were plenty.) Buffett, the investor who sees everything and thinks deeply on most everything, somehow missed it all.
And remember: In regard to mania blindness, this is the Oracle of Omahawe are talking about here… someone who has been preaching on the dangers of excess leverage and speculation since Hector was a pup. Last week that same great student of experience tried to pass himself off as deaf, dumb and blind.
Perhaps the worst thing of all, though, is this: When pressed on his lack of influence over Moody’s strategic decision making – given that Berkshire has long been the company’s largest and most powerful shareholder – Buffett took the “I really had no clue” defense, pointing out he had no idea where Moody’s headquarters was even located.
Buffett’s further responses under pointed questioning suggested that, as the ultimate passive shareholder, he has no idea what Moody’s management is even up to the vast majority of the time. Whether genuine or no, that’s one heck of an embarrassing defense!
So, based on this latest round of evidence, the 21st-century Buffett method of investing seems to involve 1) holding large investments through periods of dramatic decline, 2) completely ignoring epic bubbles even as they blow all around, with credit and leverage danger signs screaming off the charts, and 3) taking such a passive monitoring role as to have zero awareness of the fact that management has gone off the reservation. Ouch…
Be Your Own Shepherd
Is there a deeper lesson in all this, other than “Warren Buffett is no saint?” Yes.
Your humble editor would argue that, in light of the Oracle’s feet of clay, it is best to recognize that no oneis a saint… and anyone who portrays himself as much should be viewed with a skeptical eye.
Who among us is so gifted and anointed that they should be lifted up as an icon, their every word taken as gospel? No one, that’s who. Ideas and arguments should be taken at face value – respected for their logic and sensibility or rejected for lack of same. What the world needs more of is independent thinkers… fewer shepherds and sharper sheep.
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Justice Litle is Editorial Director for Taipan Publishing Group. He is also a regular contributor to Taipan Daily, a free investing and trading e-letter, and Editor of Taipan’s Safe Haven Investor and newly introduced service Macro Trader. Justice has worked with hedge funds, traded equities for a private partnership, written multiple articles for Futures Magazine, been quoted in the Wall Street Journal, sought for market commentary by the likes of Reuters and Dow Jones, made contributions to the book, Trend Following: How Traders Make Millions in Up or Down Markets, and also filled the lead editor of Outstanding Investments, a popular natural resource newsletter.
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