Rating the Raters
S&P, Moody's and Fitch Hold Great Sway, Except With Investors
In one way, it’s been a brutal time 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 2008 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, S&P Global 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.
In March, Moody’s agreed to pay $130 million to settle claims by the California Public Employee Retirement System that it had inflated ratings on residential-mortgage bond deals before the subprime crisis. S&P had paid Calpers $125 million a year before as part of a 1.5 billion settlement over similar charges in a case that included the U.S. Justice Department and more than a dozen states. S&P had also reached a settlement with the U.S. Securities and Exchange Commission and the states of New York and Massachusetts under which the company was suspended for a year from rating securities in the biggest piece of the commercial-mortgage bond market and pay $80 million in fines. Regulators said S&P had set aside its usual methodology to win business in that market in 2011. The subprime suits were 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.” S&P charged that it was being unfairly singled out by federal prosecutors in retaliation for cutting the nation’s AAA grade in August 2011, but admitted in the settlement that it had no evidence to back that up. The 2011 downgrade had been ignored by the markets, as are many calls on government debt by all of the raters, including their downgrades of Japan and Italy in December 2014, just as investors had deemed the U.S. a better bet after S&P’s downgrade. One analysis found that since 1970, rating changes on sovereign debt have been ignored as often as followed.
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 SEC 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 SEC has set up a new office of credit ratings that reviews the companies’ methodologies annually.
In August 2014, the U.S. Securities and Exchange Commission voted 3-2 to impose new restrictions on conflicts of interest, but critics say those steps 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 rules include a strict prohibition on allowing sales motives to influence ratings. The European Union is experimenting with a requirement that companies issuing bonds use different raters, in a rotation. The SEC hoped 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. Two years later, those numbers had crept up slightly. One country that saw a competitor emerge was Russia, where the government created a ratings agency after Moody’s and Fitch pulled out over a rule that in effect required them to pledge not to withdraw ratings under outside political pressure. Globally, many critics think the best reform would be to erase requirements for ratings from government regulations altogether, leaving investors to do their own analysis.
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.
First published Feb. 5, 2014
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