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Yoshikami: Ratings Agencies- Behind the Curve

Yet more headline news of sovereign ratings downgrades in Europe, with Standard and Poor’s downgrading Greek debt to junk status, and also cutting ratings for Portugal and Spain. The other two major international ratings agencies are most likely huddling in committee meetings, plotting their next move.

Surprised by the downgrades?

For investors who did their homework, there should be no surprise at all. It was only a matter of time, and the portfolios of investors should have been positioned for the downgrade weeks, if not months, ago.

Not really a surprise either that ratings agencies are, once again, behind the curve.

The Parthenon in Greece
Scott E. Barbour | Getty Images
The Parthenon in Greece

By the time Greece shocked the investment community late last year, revealing that its 2009 budget deficit was twice as high as markets thought, many investors already started positioning their portfolios.

The investment community was already preparing for a bad scenario and what impart it would have on specific equity, bond, and foreign exchange holdings.

The ratings agencies seemed to have taken their time; again.

So the big three agencies are once again coming under scrutiny by the investment community.

Most are wondering how reliable are their ratings?

Ratings agencies are no strangers to controversy. Investors and lawmakers have made claims that they contributed to the financial crisis by giving Triple-A ratings to risky mortgage-backed bonds. These ratings helped tempt investors to take risks of huge proportions. The irony was that agencies didn't downgrade these bonds until the market had already devalued them and the underlying subprime loans had already started to default in large numbers.

I am not questioning whether the new lower ratings on the debt of Portugal, Ireland, Greece and Spain are justified or not.

Debtor Nations
Debtor Nations

The question is more of whether the initial higher ratings were justified.

I am sure the intricate methodology which ratings agencies use to conclude if companies can pay or not pay their debt are well thought out.

However, they just seemed to always be one step behind, and rarely ahead of the market in assessing credit quality.

And if that’s going to be the case, it begs the question of the role of ratings agencies and the wisdom of overly relying on their current views.

There are other ways to judge risky investments, and the credit default swap market a good alternative barometer. It started pricing in the possibility of sovereign downgrades for Greece, Portugal and Spain since last year. Time and time again, looking at credit default swap spreads has proven to be a helpful predictor of forthcoming probems.

Perhaps its time to take a long and hard look at possible conflicts of interest where ratings agencies are being paid by companies and countries (issuers) to rate them. It's like movie critics being paid by the studios to review films. Are there internal pressures to “be nice” to their paying customers to keep ratings within expectations?

The role of the ratings agencies is it to advise the investment community of a change in a company or country's risk to its ability to repay its debt. It's an important role and necessary. But unless agencies get ahead of curve they risk becoming irrelevant. AAA needs to mean more than what it has in the past.

Future trust depends on it.

Program Note: Mr. Yoshikami will be a guest with Maria Bartiromo on CNBC's Closing Belltoday at 3:20pm/ET.

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Michael A. Yoshikami, Ph.D., CFP®, is Founder, President, and Chief Investment Strategist of YCMNET Advisors, Inc., a registered investment advisory firm (www.ycmnet.com). He oversees all investment and research activities of YCMNET. He is a respected lecturer speaking frequently on market issues, tactical asset allocation, and investment strategy. Michael and YCMNET were ranked as one of the top 100 investment advisors in the United States for 2009 by Barrons. He appears regularly on CNBC and CNBC Asia and can be reached directly at m@ycmnet.com.

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