Credit Ratings Are Not Going Away

Friday, September 25, 2009

Excellent ratingCongress is grilling the ratings agencies, and there has been discussion about not relying on the credit raters anymore. (For example see The Wall Street Journal today on page C-1: “Raters Face Fresh Push in House Over Claims.”) Moody’s is in the news with a former employee talking to congressmen about the publication of known flawed ratings. Moody’s stock is down sharply. The SEC, institutional investors and analysts are discussing reducing reliance on the ratings. This won’t happen, and here’s why.

For decades, credit rating agencies have played a key role in the investment world.  Using experienced analysts, they dig into all the numbers and other information gathered from their access to insiders at the debt issuers – corporations, governments and others. This sound approach has provided the needed foundation for better valuation, investment analysis and portfolio management.

So, why are Moody’s, Standard & Poor’s and Fitch now in the hot seat? Primarily for the following reasons:

First, the now-known flawed methodologies they developed to rate Wall Street’s newly created structured financial securities. New and untested, the credit raters had to use very short history and theory to develop their rating approaches. They turned out to wildly wrong, and issues had to be downgraded.

Second, the volume and size of the downgrades were far worse than anything previously. For example, two-thirds of S&P’s top-rated (AAA) residential mortgage-backed securities from 2005-2007 were re-rated lower. Fully one-half no longer carried even an “investment grade” rating, but were dropped into the “junk” categories.

Third, the repercussions went far beyond price drops. The markets froze up and investors were unable to sell or even know what valuations should be used. For financial institutions, this caused serious problems with capital requirements and liquidity needs.

Another consideration that added fuel to the fire is the long-time business practice of having issuers pay a fee for getting their securities rated. While this may sound suspicious, it has actually worked well. The ratings agencies focus on providing their institutional investor clients with sound ratings based on the best information possible. They know that improper ratings would seriously damage their reputations and long-term success.

So, although the ratings blow-up was massive and destructive, the consideration of ignoring the credit ratings firms will pass. The raters and their ratings are a key need in evaluating and investing in credit securities, so they will continue to be used widely by the industry.

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John Tobey on Seeking Alpha

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September 2009