November 24, 2014    4 minute read

Are Rating Agencies Overrated?

   November 24, 2014    4 minute read

Are Rating Agencies Overrated?

Last week we saw Moody’s share price break the $100 barrier for the first time since it was listed on the NYSE in 1994 and Raymond McDaniel, CEO of Moody’s, recently stated that they have learned from the subprime mortgage crisis and now incorporate “real-world information’ and a “more top-down macroeconomic view” when modelling credit risk. This brings into question whether Moody’s past reputation, along with its main competitors, Standard & Poor’s (S&P) and Fitch, has been forgotten. Should investors continue to look at ratings made by these agencies when making investment decisions?

The ‘Big Three’ capture roughly 96% of the ratings industry market share with S&P and Moody’s taking 45% and 41% respectively, while the remaining 13% is left for Fitch. They are ‘nationally recognized statistical rating organizations’ and the US Securities and Exchange Commission has deemed their ratings sufficient for institutional investors to determine investments, therefore issuers go to these agencies to get their securities rated. This creates an ‘issuer pays’ market. Thus, the rating agencies’ view on the creditworthiness of a company or a country can affect whether investors, insurance companies and pension funds buy their bonds or not. Ratings ranging from AAA/Aaa to Baa3/BBB are deemed to be ‘investment-grade’ with the former being safer the latter being less safe. If a security is graded Ba1/BB+ to C/D it is labeled as ‘non-investment-grade’ with C/D referring to the issuer being in default.

Rating agencies have not been known for predicting financial meltdowns so why should investors value their ratings? There is a long list of events these agencies failed to foresee. One example is the 1994 Orange County default, the county’s bonds were rated as being of the second highest calibre, AA, and were only downgraded to that of junk-bond status, CCC, the day after it filed for bankruptcy. Leaving people questioning why this downgrade did not occur earlier.  Another example is their failure to predict the collapse of Enron in 2001. The ‘Big Three’ all downgraded Enron from ‘investment-grade’ to ‘junk’ just 4 days before its bankruptcy. Indeed, Moody’s downgraded them by 5 notches, S&P by 6 notches and Fitch by over 8 notches. There is room for error when rating the creditworthiness of a specific entity however not to such a scale that ‘Big Three’ have to downgrade them by so many notches in one go. The list goes on with their failure to predict the East-Asian crisis and consequently giving the countries hit by the shock overly conservative ratings that would ultimately worsen their financial health even further.

The rating agencies’ involvement in the 2007 subprime mortgage crisis could arguably be their worst performance to date. They were required to assess the risk of subprime mortgages that were packaged up into collateralised debt obligations (CDOs). However they were giving premium ratings to CDOs that were inherently junk bonds. At Moody’s these sorts of securities were not achieving such high ratings earlier on, due to the homogeneity of the payments from subprime mortgage pools not meeting the diversity score needed for an AAA rating. S&P and Fitch did not have this sort of score system in place, meaning they could give these CDOs premium ratings, making them more desirable agencies for clients to go to. Interestingly in 2004, Moody’s decided to get rid of this diversity score system and saw their CDO rating business increase while putting the real quality of their AAA ratings into question. Could this have been a move to make Moody’s more competitive?

An ‘issuer pays’ market is one that is susceptible to conflicts of interest. Surely a marketplace set up in this way could end up with issuers of debt buying high ratings from these agencies? This is called grade inflation; indeed studies show that “11% [of investment professionals] said they had seen a credit agency change a bond grade in response to pressure from an issuer, underwriter or investor”. We can therefore assume that rating agencies were giving undeserved ratings to bonds that people were buying due to their supposed good quality. When interest rates rose and the housing bubble burst, these AAA bonds were subsequently downgraded due to high levels of foreclosures in the subprime mortgage market.

With this said, we cannot put all the blame of the subprime mortgage crisis on the rating agencies, although they did not foresee the US house market bubble bursting, not many other people did. However, one may question the credibility of the allocation of ratings that meant investors, including pension funds, some of whom are only mandated to invest in investment grade bonds, were actually participating in more risky investment propositions.

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