Goldman Sachs obviously knows how to work the system for its own benefit. Now the investment bank is showing that it knows how to work around the system as well. Today a senior Goldman executive told Reuters that it has developed a new market-based system for rating the riskiness of debt.
The ratings agencies — Standard & Poor’s, Moody’s Investments, and Fitch Rating — were singularly blind to the risks in the housing market, stamping triple-A ratings on subprime-backed mortgage bonds. Despite their subprime performance, the agencies remain dominant because investors haven’t figured out ways — yet — to ditch them. The Goldman ploy could signal a new trend.
“Clients often give investment guidelines determined by credit ratings, but we don’t think that’s the way to think about risk,” said Andrew Wilson, global co-head of fixed income and currency at Goldman Sachs Asset Management (GSAM).
Instead, GSAM’s approach is to segment credit spreads into five groups, to assess how issuers are trading in relation to their peers, Wilson told Reuters in an interview.
Next, institutional investors will need to re-write their investment rules. Many require that institutions buy only investment-grade securities, as rated by one of the major agencies. And, by extension, they must sell when the ratings fall beneath a pre-set level.
Goldman’s move opens doors to other creative solutions for working around the agencies. And it couldn’t come a moment too soon: Rating agency downgrades can wreak havoc on stock prices because of the way investment rules are written for so many institutions. Watch out for Thursday, when the government reveals the results of its stress test. In anticipation of this moment, S&P put dozens of banks on its watch list with a negative outlook. Nothing like independent thinking and analysis.
Goldman notes that the rating agency system of examining bonds is far from dynamic.
“Ratings agencies are good at static analysis but they are less good at forecasting,” he said.
The strategy will take an unconstrained, or “opportunistic” approach, investing across the credit spectrum and assessing how cheap investment grade credits are relative to high yield, for example.
The potential weakness in the Goldman system: When market bubbles form, will the analysts at Goldman Sachs Asset Management unit be able to recognize what is overbought? Will Goldman be able to spot group-think for what it is? No system is perfect. But now is the time to try things out for a new Wall Street.