The three major ratings companies, Moody’s, Fitch, and Standard and Poor’s, rated baskets of mortgages, bonds and other instruments, huge swathes of which are either in default, have gone bankrupt, are having to be bailed out with tax payers’ funds, or, if they still have value, have lost much or most of it. Yet the ratings companies still exist and, inexplicably, they are still been viewed by the US Federal Reserve as having a role to play in the future rating of financial instruments in the USA. As the Wall Street Journal
recently pointed out in an editorial on 3 January 2009, it is almost beyond belief that the ratings companies that were instrumental in getting the USA into its current financial crisis are now being viewed as part of the emerging solution, even though they were a critical part of the problem. Why is this so?
Part of the problem is that until recently no one has presented an alternative way to rate companies. The ratings companies have a quiet oligopoly, which they fiercely protect. The methods they use to rate companies and financial instruments are outdated and, from a fundamentalist point of view, unsophisticated. They rely principally on financial history whose directions and trends are extrapolated into the future. Recent history is decisive proof that these methods do not work when business conditions change significantly. However, the lack of an alternative approach has stymied all efforts to develop new forward-looking models that do not just rely on extrapolating current trends into the future.
This is now changing. The field of behavioral finance has emerged in the last 20 years as a new model to describe financial and economic phenomena. Behavioral finance and economics are different to their classical cousins in that they drop the classical assumption that financial and economic decisions are always rational. They now inject a new idea into these disciplines, that consumers and economic managers sometimes make financial and economic decisions irrationally, or to adopt the de rigueur terminology, under conditions of mixed rationality.
However Wall Street and the ratings agencies never picked up on behavioral economics and finance so their models could never integrate these factors, with predictable results. Their models failed. With behavioral economics and finance there exists a new paradigm on which to build new models of how companies act and how to predict their future valuation. However academic models have still not made the leap to showing how these behavioral finance models can be applied to specific managers and companies to predict their future valuation and profitability prospects.
Yet even this has changed. In the past few years, new models have emerged built on a behavioral finance paradigm, which allow these techniques to be applied at the level of the individual, the management team and the individual company. These models dramatically extend the power of behavioral finance so that it can be harnessed to equity and bond valuations.
One of these models is from the Perth Leadership Institute (www.perthleadershjip.org) based in Florida in the USA and no doubt others will soon emerge. According to its CEO and Founder, Dr. E. Ted Prince, “The ratings companies are still stuck in the Middle Ages as far as their fundamental conceptual techniques are concerned. Until they adopt behavioral finance techniques and integrate them into their ratings systems, their methods are basically astrology, not science.”
This has revolutionary implications for the ratings companies, and indeed for all of the industry requiring corporate and equity analysis. Current ratings methods are backwards looking because they are based on history. However, behavioral financial ratings are forward looking because behavior is stable over time. For the first time a method exists to provide ratings with true predictive power.
Whether or not the ratings companies will do anything about this is a moot point. Existing industries are infamous for insulating themselves from new models to protect their old ways of doing things, even if they do not work. On all indications we can expect the ratings companies to act in the same way.
The most likely outcome is for new ratings companies to emerge based on new behavioral finance paradigms. That way investors, stockholders and homeowners will have a new and better way to see whether their money is likely to be invested wisely.
It cannot happen too soon.David P. Michaels - New York - Bureau Chief, MercoPress