Do credit ratings (by Moody's, S&P, and Fitch) have any relevance?

Question

The credit rating agencies (Moody's, S&P, Fitch) issue credit ratings for corporations as well as different debt products.

Their recent track record has been anything but stellar.

It was only four days before Enron filed for bankruptcy that Enron's credit rating was changed to be below "investment grade".

During the housing boom mortgages were purchased by special purpose vehicles (SPVs) which financed itself by issuing bonds which were rated by the agencies. The bonds issued by the SPVs were then purchased by collateralized debt obligations (CDOs) which also funded itself by issuing bonds that were rated by the agencies. A good explanation of the process is here.

What is most fascinating is this statement from this article:

In 2006 alone, Moody’s gave 9,029 mortgage-backed securities a triple-A rating,” said Angelides, whose panel was created to investigate the causes of the financial crisis as Congress debates the most sweeping overhaul of banking regulations since the Great Depression. “To put that in perspective, Moody’s currently bestows its triple-A rating on just four American corporations.

These triple-A and investment grade bonds were sold to banks and retirement funds and then downgraded less than a year later. Many from investment grade to junk.

Many high-level ratings had to be lowered. In 2006, 83 percent of triple-A products were downgraded and in 2007, 89 percent of those considered investment grade were reduced to junk, Angelides said.

This bond bonanza was great, however, for the credit rating agencies since they got paid for rating all the bonds that were issued:

S&P and Moody's earned as much as three times more for grading the most complex of these products, such as the unregulated investment pools known as collateralized debt obligations, as they did from corporate bonds.

I didn't realize until I read up on this that the issuer of the debt is the one who pays the rating agency. This seems like a conflict of interest. Meredith Whitney, a credit analyst at Citi, who predicted the banking crisis, is going to start a new credit rating agency. Unfortunately she is using the same payment scheme - the issuer of the debt pays the credit rating agency. It seems like there is a better model. I'm not sure what that is however.

There is a funny ending to all this: Moody's is now considering downgrading S&P. Let the cannibalism begin.

So do the credit rating agencies have any relevance?

Answer 1

The problems with ratings and the interpretation of ratings is that they are retrospective, and most people read them as prospective. They basically tell you that debtor is solvent right now.

What does that mean? It means that the ratings are based on the audited financial statements of a company, government or other organization issuing debt. So, in the best case scenario where the rating agency is acting properly, they are still dependent on folks with fiduciary responsibility telling the truth. And even if they are telling the "truth", accounting rules make it possible to obscure problems for years in some cases.

Municipal goverments are a great example of this... the general obligation bonds cities and even states with deep structural budget problems still get good ratings, because they are solvent and have sufficient operating cash to meet obligations today. But towards the end of a 30-year bond's life, that may not be the case anymore unless they dramatically alter their budgets.

At the end of the day, ratings are one aspect of due diligence. They are useful screening devices, but you need to understand who you are lending money to by purchasing bonds and diversify your holdings to protect your wealth.

The problem, of course, is when the trustees of your pension fund invests in garbage assets after getting a sales pitch on the beach in Hawaii, then conveniently place all of the blame for that bad investment on the rating agency. You unfortunately have zero control over that.

Answer 2

They've pretty much shot any credibility they possessed.

Follow the money.

Answer 3

I like Muro questions!

No, I don't think they do. Because for me, as a personal finance investor type just trying to save for retirement, they mean nothing.

If I cannot tell what the basic business model of a company is, and how that business model is profitable and makes money, then that is a "no buy" for me. If I do understand it, they I can do some more looking into the stock and company and see if I want to purchase.

I buy index funds that are indexes of industries and companies I can understand. I let a fund manager worry about the details, but I get myself in the right ballpark and I use a simple logic test to get there, not the word of a rating agency.

If belong in the system as a whole, I could not really say. I could not possibly do the level of accounting research and other investigation that rating agencies do, so even if the business model is sound I might lose an investment because the company is not an ethical one. Again, that is the job of my fund manager to determine. Furthermore and I mitigate that risk by buying indexes instead of individual stock.