Monday, July 8, 2013

S&P defends its ratings by saying investors wouldn't rely on them

Defending itself against a US Justice Department action, S&P said that investors in RMBS deals wouldn't rely on their ratings in their investment decision.

Why might an investor have relied on S&P's rating?

Because part of the S&P business model is the representation that the rating firm has access to information that is not available to other investors.  For example, S&P and other rating firms are privy to confidential information about company business plans.

Regular readers know that it was not until the fall of 2007 that S&P and Moody's testified before the US Congress and told investors that they did not have access to any information that the investors had access to.

At that point, the structured finance market effectively froze as investors realized they could not value the securities they own because they did not know what was the current condition of the collateral supporting these securities.

Why might an investor not have relied on S&P's rating?

The only reason that an investor would not rely on a rating is if it had all the necessary information so that it could independently assess the underlying assets.  If it had the necessary information, the investor could conduct their own due diligence.

What would it take for an investor to have the information so they could do their own due diligence?

Besides information on the terms of the mortgage and the borrower, the RMBS deal would have to provide observable event based reporting and disclose on an ongoing basis all activities like a payment or delinquency that occur with the underlying collateral before the beginning of the next business day.

Did RMBS deals provide observable event based reporting?


Having said that there wasn't adequate information for an investor to know what they are buying let alone know what they own, whether an investor relied on S&P's rating or not, the buyer or seller of an RMBS deal was simply gambling.

Our financial system is based on the philosophy of disclosure and the principle of caveat emptor (buyer beware).  This makes buyers responsible for losses on their investments and gives them an incentive to assess the disclosed data.

In the case where there is no information disclosed, buyers are suppose to be aware that they cannot independently assess the risk and value of the security and therefore cannot make a buy, hold, sell decision by comparing their independent valuation against the price shown by Wall Street.

When a buyer cannot make an investment decision, they have to know they are simply gambling if they  have any exposure to the security.

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