Ratings agencies are an important source of information for investors. However, it is difficult to judge the accuracy of the information because while ratings agencies may have the capacity to run simulations on a given set of assumptions, they cannot be certain about the information given to them

There is a common expression in English, 'There are three types of lies: lies, damn lies and statistics.' There have been many attempts to attribute the expression to a person without success. The closest and earliest seems to be in a different area, the law. In a reference dated to 1885, the quote goes "A well-known lawyer, now a judge, once grouped witnesses into three classes: simple liars, damned liars, and experts." For investors there can be nothing more important than statistics and experts. One of the most difficult things for markets to do is to judge the accuracy of information. But to make money this analysis is perhaps the most important of all.

One excellent way to determine the quality of information is to see who is attacking it. One appalling example came recently from the president of the European Commission Josée Barroso. This week Moody's downgraded Portugal's bonds four notches to junk. President Barroso responded by accusing Moody's of "mistakes and exaggerations". He felt that the experts at Moody's were incompetent to make the determination of Portugal's financial health. Instead he proclaimed that "our institutions know Portugal a little bit better". Perhaps, but as everyone is well aware, President Barroso's institutions have a bit of a bias.

The bias was echoed by Wolfgang Schäuble, the German finance minister, who said "We can't understand the basis of this announcement," and then threatened "to break the oligopoly of the ratings agencies." Both statements basically confirmed what the markets knew anyway, that Portugal's bonds were junk and that Moody's recognition was a rather late confirmation.
 
It was not just the Europeans who were annoyed with the ratings agencies that had given them bad marks. The American government was annoyed as well. When S&P cut its outlook for US bonds in the midst of budget negotiations between the White House and congressional Republicans, senior US Treasury officials questioned the timing and accused S&P of being misinformed about the budget talks.
 
It is not that the ratings agencies have never been wrong before. They are still recovering from their horrendous calls. Four weeks after Moody's rated Enron's debt as investment-grade, the company declared bankruptcy and defaulted on its bonds. But what really caused the credit agencies downfall was their work rating structured finance/subprime.

Structured finance was a method developed in the 1980s to turn many disparate mortgage loans into standardised, regimented and easy-to-assess bonds. The process could be manipulated to provide different degrees of risk. Exactly how the deal was structured depended upon what rating it was trying to get. So the ratings agencies were brought on board early, rather than after the products were created. This totally changed the ratings agency's bias. They were no longer an independent expert witness, but were providing a service for clients. In the case of structured finance, it meant that they were working for the creators of the products, the investment banks, and not investors. The rest, as they say, is history.

Because the ratings agencies have a particular bias that governments don't like, the governments decided that since they are free from bias, that they should create their own taxpayer funded ratings agencies. A plan by the European Union (EU) fortunately received a poor reception from the European Central Bank because it would need "extensive data, models and experienced staff" and could take years for it to become fully effective."

Although start-up problems prevented the formation of a ratings agency owned by the EU, they did not bother China. China has three credit ratings agencies, Chengxin International Rating Co, which is 49% owned by Moody's, and China Lianhe Credit Rating Co, 49% owned by Fitch Ratings Inc. The third and most interesting is Dagong. We don't really know exactly who owns Dagong. It is not revealed on their web site. We do know that it works closely with the Chinese government and at times can be particularly protective of what it considers its 'national sovereignty'.

It was denied an application by the US securities watchdog, the Securities and Exchange Commission (SEC), to become a "nationally recognised statistical rating organization", or NRSRO, a designation that allows a firm's ratings to be used as benchmarks in US laws and regulations, because "it was not possible at this time for Dagong to comply with the record keeping, production and examination requirements of the federal securities laws". Dagong refused to comply because it said it would have to remove 'state secrets' from documents requested by the SEC.

So which expert is right? Well, none of them. Moody's ratings software has the ability to run over a million simulations on a given set of assumptions, but part of their problem were errors in the code to say nothing of the information given to them. So investors like jurors at a trial must weigh the word of an expert against their bias and remember that the truth does not belong to any one.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)