Six-Inch Hooker Heels & A Tramp Stamp

We look forward to Bill Gross’ Investment Outlook every month.  It’s a must read for every investor, even those that are somewhat bored by bonds (we are not admitting guilt here).  His most recent piece did not disappoint.  We thoroughly enjoyed his commentary on the rating agencies, which we’ve recapped below:

In all of the hullabaloo over Goldman Sachs, a CQ analysis of the rating services – Moody’s, Standard & Poor’s and Fitch – has escaped front-page headlines. Not that a number of observers haven’t been on to them for a few years now, including yours truly. Back in July of 2007 some of you will remember my description of their role in the subprime crisis. “Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels and a ‘tramp stamp.’” Now, it seems, I was a little long on humor and a little short on the reality. Tramp stamp and hooker heels do not begin to describe the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the subprime craze, as well as reflecting the general deterioration of investment common sense during the past several decades. Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbors. The result has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don’t go bankrupt. Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.

Such services, however, while necessary in the ongoing scheme of financial regulation, are overpriced as well as subject to the influence of the issuer, which in turn muddles their minds and clouds their judgment to say the least. E-mails from S&P employees have been cited discussing massaging subprime statistics in order to preserve S&P’s market share relative to their two competitors. PIMCO’s Paul McCulley said it as only he can – “[The breakdown of our financial system] was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out the fake IDs!”

Still, as future bond issuers belly up to the bar with their rating agency seals of approval, it is incumbent on the buying public to treat those IDs with a healthy skepticism. Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three, benefiting from their timidity and lack of common sense. Take these recent examples for instance: S&P just this past week downgraded Spain “one notch” to AA from AA+, cautioning that they could face another downgrade if they weren’t careful. Oooh – so tough! And believe it or not, Moody’s and Fitch still have them as AAAs. Here’s a country with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels, and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!

It seems that someone is finally paying attention as per the company’s recently filed 10-Q:

On March 18, 2010, MIS received a “Wells Notice” from the Staff of the SEC stating that the Staff is considering recommending that the Commission institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006.

Further complicating matters for the company is the prospect that new regulation gives investors the right to sue the credit rating agencies for “knowingly or recklessly” failing to conduct a serious investigation of the facts or to obtain analysis from an independent source. Buffet has been an aggressive seller of shares around $25 or better despite defending the company at Berkshire’s Annual Meeting.