Sunday, January 4, 2009

About credit ratings

Anchoring risk management on mainstream credit ratings has resulted (and will in the future) badly for many investments. Accurate forecasts have value, conventional credit rating agencies do not. A lot of reasons point to an imbalanced system, but I think an anecdotal analysis should suffice for most of us.

Trend followers (euphemism for newbies)

Since early 07, many have raised alarms regarding the credit, housing bubbles, (e.g. Schiller, Whitney, and etc.) The credit rating agencies however remained optimistic. The mainstream investment trusts like those New Zealand finance companies relied entirely on the overly confident ratings and kept on buying. Then it started to wobble, and with each decline credit ratings slipped.

So what is the pattern here? Can the average Joe Blow provide practically identical credit ratings as those of the mainstream agencies? Yes and YES.

Here is what you do to mirror Moody’s or S&P ratings. If the market has ended lower the past quarter, lower average credit ratings, and vice versa. This is the basic concept of “trend following” or herd mentality, where you’re simply led instead of taking lead.

It is that simple, even my grandma can do it.


Many NZ based investment firms have lost everything due to over leveraging. ING credit unit trusts (Diversified Yield Fund, Regular Income Fund) hurt a lot more people with their seemingly qualified teams. These funds consist of mostly CDOs (Collateralized Debt Obligations), and even the salesmen could not explain exactly who backs the debt. Their unit prices were at roughly $1.00 June 07.

It is unfortunate that many New Zealanders became victims of this via slick selling. But then again that is the price when they chose not to do the necessary research. Hence, these investors/speculators are termed “dumb money” on Wall Street.

Bottom line

Now that we know how credit ratings work in general, you can distance yourself from the patsies, and gauge sentiment of retail investors. When credit rating for certain instruments remains high while you discover weaknesses (like some of us in 07), the extreme newbie optimism meant favorable opportunities to short. Pretty easy right?

0 Reflections: