Visti da Wall Street, Do the Rating Agencies Deserve an F?

by Harvey D. Shapiro.

As MF Global was hurtling toward one of the largest bankruptcies in U.S. history this fall, Moody’s Investor Service and the Fitch Group, two of the three major global credit rating agencies, didn’t downgrade its bond rating until a few days before the firm went bust and the third rating agency,, Standard & Poors Corp., didn’t downgrade MF Global to junk bond status until after the firm filed for bankruptcy on Oct. 31.
For many investors, it was déjà vu all over again. Enron, after all, had remained investment grade until four days before it went bankrupt. And the preferred stock issued by the Federal Home Loan Mortgage Corp. (Freddie Mac) had Moody’s top rating one day and then plummeted several notches to just above “junk” status a day later.
The list of complaints about S&P, Moody’s and Fitch – the three credit rating agencies (CRAs) that collectively account for more than 90 percent of the global market for ratings – keeps growing. Again and again, they have displayed excessive optimism when complex bond issues come to market while offering only belated warnings when issues fall from grace.
To be sure, predicting the future is not easy, and anyone can be surprised when a company and its bonds fall upon hard times. But the rating agencies were repeatedly overly positive about structured mortgage products and other complex securitizations. Despite being rated AAA or Aaa by the three CRAs, one analyst has calculated that $340 million worth of CDOs issued by Credit Suisse ended up generating losses of about $125 million for investors during the financial crisis. More recently, the rating agencies have been consistently slow in downgrading the sovereign debt of European issuers.
Although the CRAs are supposed to function as the canary in the coal mine for investors, warning them if the creditworthiness of an issuer changes, studies show that that if a company’s credit quality is deteriorating, the yield spreads on its bonds often expands well ahead of any downgrade in its ratings. That suggests that the market leads rather than follows the ratings.
Despite what many see as a dubious track record, however, the rating agencies continue to be critical to the bond market. Even a hint of a rating change has immediate and severe consequences on the prices of the relevant securities. For many investors around the world, a bond without a rating is considered untouchable, and conversely, a rating from at least two of the big three is all they need to know in order to buy a bond. Whatever the intricacies of an issue, just as a rose is a rose is a rose, a Double A is a Double A.
As the European Union’s Internal Market Commissioner Michel Barnier has said, “Ratings have a direct impact on the markets and the wider economy.” He added, “They are not just opinions.” And the problem, says, Lord Peter Levene, chairman of Lloyds of London insurance market is that “The rating agencies failed the world economy in spades in the past.”
Many thoughtful investors continue to wonder whether the ratings process can be improved. For many critics, a central problem is the rating agencies’ business model. The ratings are paid for by the issuers, not the investors, and many believe this creates conflicts of interest that inevitably result in skewed ratings.
The rating agencies insist that they are independent, they have codes of ethics, and investors wouldn’t rely on them if the ratings weren’t credible, etc. etc. But many believe he who pays the piper must inevitably call the tune. Certainly the optics are worrisome. What if restaurants paid to be rated in the Michelin Guide? What if publishing companies paid to have their books reviewed? What if theaters paid the salaries of the critics who write for newspapers? .
Actually, S&P and Moody’s, whose histories each date more than a century, originally sold their ratings to investors on an ongoing basis, much like a subscription to a magazine or newspaper. Indeed, the U.S. courts have consistently protected the rating agencies from angry issuers under the First Amendment of the U.S. Constitution, guaranteeing freedom of the press. If you thought you deserved an A and you were rated BBB, well, the rating agencies are entitled to their opinions much like a newspaper, and there has been nothing an issuer could do.
The courts have continued to hold that view, but in the 1970s, amid the proliferation of copying machines and the consolidation of institutional investors, the rating agencies concluded that their circulation growth was limited, and they switched to charging the issuers. Meanwhile, investor reliance on ratings has been bolstered by regulators. Since as far back as 1931, American regulators have sought to restrict life insurance companies and other institutions from holding securities whose ratings were below a certain level and to design capital requirements so that fewer precautions are required when investing in securities with higher ratings.
To further institutionalize this process, in 1975 the Securities and Exchange Commission (SEC) specified that the ratings used had to be from a Nationally Recognized Statistical Rating Organization (NRSRO), and since then the Congress and other regulatory bodies have taken up this approach. This quasi-licensing has created significant barriers to entry and helped to further enshrine the big three.
Similarly, under the Basel II agreement of the Basel Committee on Banking Supervision, banking regulators allows banks to use credit ratings from certain approved CRAs, and when calculating their net capital reserve requirements, and the higher the rating, the less capital required.
Issuers have also benefitted from the semi-official status of ratings: For years they could use a scaled down prospectus in the U.S. if they have sold bonds before and had a credit rating above a certain level.
The critical importance of good ratings has led to several developments in the bond market. One was the dramatic growth in municipal bond insurance. The “monoline” insurers, like AMBAC and MBIA, were created to insure the payment of interest and principal on bonds issues by state and local governments in the U.S. A double BB government agency could purchase insurance from an insurer like MBIA, which had a Triple A rating, and the municipality’s bonds were magically transformed into Triple A. The reduced interest costs the issuer would incur as a Triple A borrower totaled far more than the insurance premium it would pay to MBIA. That worked fine until the last recession, when the vast exposure of the bond insurers troubled investors.
Even more fundamentally, a cottage industry has grown up around preparing issuers to get the best possible rating. For years, investment bankers preparing to bring a corporate bond deal to the market studied the CRAs’ well-documented methodologies, and massaged their clients’ balance sheets before seeking a rating. Do you want to be a Triple B or a single A? It’s clear what each rating requires. So, like a movie star who goes on a diet before filming begins, companies planning a bond issues might, for example, reduce their debt to just the right level to get a higher rating, and this would permit a lower interest rate on their bond issue. Once the bond is rated and sold, the company can go out borrow a lot more money from their bank.
(There’s a different dynamic in rating sovereign issues. These ratings are provided free to a country. But as S&P found when it recently downgraded the U.S. and France, there is the potential for substantial political tension when CRAs judge those who regulate them.)
The interplay between issuers and rating agencies became even more self-conscious as securitization took hold over the last two decades. As a transaction was being put together, investment bankers would often consult with the CRAs to see precisely how to structure each tranche in order for it to receive the desired rating when it would be issued.
Because these securities were new and complicated, investment bankers needed substantial guidance and investors needed to rely heavily on ratings, but the raters lacked historical data or experience to back their ratings. Nonetheless, the CRAs eagerly rated a variety of exotic offerings. And because they were paid by those they were judging, critics say, this created perverse incentives, and during the 2005-3007 credit boom, the agencies recklessly awarded Triple A ratings to exotic structured instruments that they scarcely understood. Yet it was precisely because of those high ratings that investment banks were able to sell things like CDOs Squared, which combined thousands of loans and derivatives and separated them into complex tranches.
The CRAs profited from the proliferation of issues to be rated. In the three-year period ending in 2007, S&P’s profits rose nearly 75 percent, to $3.58 billion compared to the three-year period ending in 2004, while over the same period Moody’s profits grew more than 65 percent to $3.33 billion.
In an April 2011 report to the U.S. Congress, Senators Carl Levin, a Democrat from Michigan, and Tom Coburn, a Republican from Oklahoma, said the CRAs “weakened their standards as each competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom.”
The flaws and shortcomings exposed in rating complex structured securities that tanked have only deepened existing concerns about the rating agencies. Nonetheless, solutions remain illusive.
One approach often put forward is to reduce investors’ simplistic reliance on ratings by reducing the official standing which regulators had earlier spent years constructing. In 2008, the SEC revised its rules so that would-be issuers no longer needed a rating in order to use short-form registration for proposed public offerings. There were also provisions in 2010’s broad-gauged Dodd–Frank Wall Street Reform and Consumer Protection Act which sought to remove references to credit ratings in existing SEC rules in an effort to get investors to look beyond the ratings.
Yet another alternative is to encourage competition. If the current oligopoly were replaced with a larger group of rates, many believe, that might improve quality as CRAs had to compete for credibility. One way to do facilitate competition is to remove the regulatory advantages that enshrine the big three. Let issuers use any ratings they want, and let the market decide whether they approve. In fact, in the wake of the 2008-09 financial crisis, several new rating agencies have been created, most notably the Kroll Bond Rating Agency, founded by a well-known investigatory agency. There are currently ten firms registered with the SEC as NRSROs.
But efforts to foster competition face a conundrum. No major issuer wants a rating from a minor rating firm just as no major company can offer a financial statement approved by an obscure accounting firm. It’s no coincidence that there are only four major global accounting firms and three major global rating agencies. In any case, competition could also backfire: Too much competition might well encourage some firms to hand out high ratings in order to attract business.
Yet another solution is to tweak the “issuer pays” business model to give it more integrity. Under one EU proposal, a CRA that rates an issue would be supplanted after three years by another CRA. (Precisely the same concept is being proposed for accounting firms.) This way, the rating agency has no incentive to pull its punches because it can’t alter its future stream of business from an issuer. Moreover, in November, the European Commission proposed to achieve more accountability by moving away from the freedom of the press safe harbor and permitting investors to sue CRAs which display “gross negligence.”
Many believe the only real solution would be to change the business model back to getting investors to pay for ratings. But no one can solve the “free rider” problem: If an investor buys a report from Moody’s on an impending bond issue, yes, the investor might pay thousands for it – and he or she might quickly photocopy the document or forward the e-mail to a bunch of fellow investors. Investors are accustomed to getting research for free, and as stock brokers have found in their efforts to charge for equities research, what once was free is very hard to sell.
So while there is tinkering around the edges in the U.S. and Europe, the ratings game goes on, like some kind of kabuki ritual: Periodically, a financial crisis unfolds. The first response of the press and the public is to ask: Where were the regulators? The second question is: Why didn’t the rating agencies warn us?
The agencies know their part in the ritual. Their executives show up at U.S. Congressional hearings and at various public events, they give interviews on television and in newspapers. They remind investors that they need to look beyond the three-letter ratings and read the often voluminous accompanying reports. If only they had done so, they would have noticed the obscure paragraphs and footnotes that hint at the potential for problems. See — we warned you all along. Meanwhile, the CRAs remain an indispensable part of the investment process around the world.
Ultimately, the answer to the rating problem is for investors to do their own research. The rating should be one input, but there should be others. Just as many people read more than one review before investing $10 to see a movie, they should read more than two ratings before investing $50 million in a bond issue. Alas, that concept gets a Triple A for wisdom but only about a Double B for practicality. Whether an individual is choosing a restaurant or a bond issue, it’s always tempting to reduce the complexity of the decision to a few stars or a few letters of the alphabet.