In one way, it’s been a brutal five years for the big bond-rating companies, which have struggled to defend their reputations since the good ratings they gave to bad bonds helped start the financial crisis. In another sense, they’re doing great; they’re busy and making piles of money. The U.S. regulators that made ratings by Moody’s, Standard & Poor’s and Fitch into a semi-official seal of approval in the 1930s may be trying to reduce their influence, but it isn’t working. The most sophisticated investors, on the other hand, are paying less attention to ratings than ever.
When it comes to bond ratings, paradox rules. The source of the rating companies’ new profits is the very economic meltdown they helped set off. After the Federal Reserve responded by bringing interest rates down to near zero, bond sales soared, boosting demand for the ratings the companies charge hefty fees to provide. Regulators say the rating firms play too big a role in the financial markets, but when it comes to government debt, the markets routinely ignore their conclusions: Investors deemed the U.S. a better bet after S&P cut the nation’s AAA grade in August 2011, French debt rallied after its rating dropped in January 2012 and S&P’s February downgrade of Puerto Rico came months after the markets had priced its debt as risky. S&P is being sued separately by the U.S. Justice Department and by 19 states and the District of Columbia, but six of those states still require that their pension funds invest only in bonds rated by the companies. Numerous investors have also filed suits that accuse the ratings companies, as the government cases do, of fraudulently misrepresenting the risk of mortgage-backed bonds. Those suits have been helped by e-mails like one from an S&P employee saying, “Let’s hope we are all wealthy and retired by the time this house of cards falters.” The companies had always been able to fend off litigation about bad ratings by arguing that their reports were opinion protected by the First Amendment. But the plaintiffs in the new cases charged the companies gave out gold-star ratings they knew weren’t deserved.
Often called “agencies,” raters are actually profit-seeking companies. John Moody, a former journalist, helped start the business in 1909 by issuing letter grades to rank the ability of railroad companies to repay loans. Ratings became so widely used that in 1936 the U.S. Comptroller of the Currency banned banks from holding bonds not rated investment grade. The Securities and Exchange Commission further weaved Moody’s, S&P and Fitch into the regulatory fabric in 1975 by naming them “Nationally Recognized Statistical Rating Organizations” and requiring investors in some circumstances to buy only bonds with their seal of approval. That led to lower borrowing costs for many companies and municipalities, since investors could think they had expert guidance to rely on. Today, though, ratings upgrades don’t necessarily translate into lower yields, or downgrades into higher ones. That’s because professional investors usually have priced in the moves well before they happen, leaving raters in the position of catching up to the market. Ratings do matter more in markets that are complex or thinly traded — exactly the kind that blew up in 2008. To prevent a repeat, the Securities and Exchange Commission has set up a new office of credit ratings that reviews the companies’ methodologies annually.
Critics say the changes put in place by the SEC don’t go far enough or address the central conflict of interest: The rating companies are paid by the issuers whose bonds they’re evaluating. The European Union now is experimenting with a requirement that companies issuing bonds use different raters, in a rotation. The SEC is hoping to promote competition in a market where the top three companies won 95 percent of sales in the U.S. in 2012, and as much as 90 percent globally. The problem is that more companies mean more options for Wall Street to shop around for top grades. Many critics think the best reform would be to erase raters from regulations altogether, leaving investors to do their own analysis. S&P seems to agree with that attitude of caveat emptor. It has said it will contest the government’s charges “vigorously”and called the suits meritless. S&P also moved to have the federal case dismissed on the grounds that no one should be basing investment decisions on its reports, which it described as “mere puffery.” The motion was denied.
The Reference Shelf
- Bloomberg News article on Wall Street shopping for the best credit ratings.
- Primer of the history of credit ratings by New York University Professor Richard Sylla.
- The Securities and Exchange Commission’s annual report on the state of the credit ratings business.
- The U.S. Justice Department’s lawsuit against S&P.
- National Bureau of Economic Research paper by Efraim Benmelech of the Kellogg School of Management and Jennifer Dlugosz of the Olin Business School on the role of credit rating agencies in the 2008 financial crisis.