Fitch Ratings Says Bond Defaults Don’t Mean Grades Are Wrong

Fitch Ratings, the third-largest credit rater, is telling investors that bond defaults aren’t an indication that its grades are “wrong.”

“To say an opinion on future default likelihood for a ‘A’, ‘BBB’ or ‘BB’ rated issuer that eventually defaults was wrong ignores ratings’ role as a product that acknowledges -- bluntly and clearly -- that default is a possibility at each and every level of the rating scale,” analysts led by Jeremy Carter wrote in a report dated today that seeks to explain to investors how to interpret the firm’s grades.

During the housing boom, credit raters lowered their standards to win business, helping spark the worst financial crisis since the 1930s, according to the Federal Crisis Inquiry Commission. Congress responded with the 2010 Dodd-Frank Act, which mandated that the U.S. Securities and Exchange Commission reduce the reliance on credit ratings in federal regulation.

Fitch, the third-most active rater behind Standard & Poor’s and Moody’s Investors Service, has sought to improve its analysis of structured products by giving greater weight to the judgment of its analysts and reducing the reliance on quantitative models.

The SEC is scheduled to meet May 14 to discuss a plan supported by Senator Al Franken of Minnesota that would create a board to select which firms grade bonds that pool together other debt, instead of leaving it to the banks that pay the credit raters.

Default Rates

Grades aren’t to be used to determine default rates, instead for assessing a borrower’s “relative vulnerability to default,” Fitch Ratings said.

Opinions on the creditworthiness of debt are designed to be stable, taking into consideration troughs in business cycles and liquidity risks. Grades are heavily dependent upon expected cash generation, profitability and leverage, Fitch said. Ratings don’t convey a specific default rate, since those vary over time, sector and region.

Investors use grades from Fitch to meet regulatory requirements. In 1975, SEC regulations designated S&P, Moody’s and Fitch as Nationally Recognized Statistical Rating Organizations, or NRSROs. There are now 10.

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