Monday, May 31, 2010

Bond Rating Agencies Yield Junky Results

Think a certain credit rating means something?  Think again!

Amid the financial crisis which enveloped the global financial system in 2008-2009, Standard & Poors (S & P) and Moody's played a central role.  So much paper with sub-prime mortgages defaulted that were originally given Triple A ratings, that any scintilla of crediblity these agencies had has vanished.

The meaning of an AAA rating is that the likelihood of default is virtually nil.  Yet, in the 2008-2009 period, thousands of Collateralized Debt Obligations (CDOs) not only defaulted, but suffered principal losses of up to 90% of face. 

The problem with the entire business of rating credit has been that issuers "pay" to have their bonds rated to make them marketable to institutional investors, who often base their asset allocations on how highly rated an issuer is.  Since S & P and Moody's are paid by the issuers, they're beholden to their customers and not the investors that will ultimately rely on the ratings themselves. 

Another side-effect is that the rating agencies are incredibly slow to issue downgrades.   A recent example is Spain, which was just downgraded by Fitch to AA+ from AAA.  Spain's bonds already trade at levels more akin to comparable issuers rated either A or BBB with yield spreads in excess of 150 basis points.  When issuers ARE about to be downgraded, they often fight the downgrade, delaying it further.

Credit ratings have ZERO informational content.  Studies performed by my own firm, Helix Investment Partners, indicated that the yield spreads needed to compensate investors for the probability of default were highly correlated with 3 market driven variables:  a company's market capitalization (share prices times shares outstanding), its market-adjusted DEBT/EQUITY ratio (debt divided by market capitalization) and the volatility of the issuer's common stock.

Once these variables were considered appropriately, a company's credit rating was absolutely meaningless statistically,  In all likelihood, the 3 aforementioned variable captured imputed information much more accurately since money is on the line.  A credit rating imperfectly captures these market indicators and is, therefore, nothing but a poor cousin.

Last week, in a Senate hearing, former Moody’s and S&P employees admitted that the agencies tried to please investment banks that were paying big fees to get high ratings.  The three largest ratings companies, Moody's, S&P and Fitch (a unit of France's Fimalac SA), generated combined revenues of $3.6 billion on bond ratings last year.

Nowhere has the failure of the rating agencies been more prounced than in the mortgage securities market.  Of all the issues assigned Triple A ratings in both 2006 and 2007, a full 90% have been downgraded to junk or defaulted!

On the corporate side, there are now only 4 issuers carrying Triple A ratings:  Automatic Data Processing (ADP), Johnson & Johnson (JNJ), ExxonMobil (XOM) and Microsoft (MSFT).  Even Berkshire Hathaway, whose bond yields are LOWER than Uncle Sam's, does not qualify for this very small club.

Yet, Triple A ratings on collateralized mortage paper was given out freely.

There is no need to even have this industry.  The bond market, including the Credit Default Swap (CDS) market, is much more accurate in pricing in true credit risk at NO cost to the issuer.  CDSs reflect the cost of "insuring" debt against default and have an excellent record of reflecting the latest information.  By comparison, credit ratings are adjusted very infrequently and only "rubber-stamp" what the market already knows and has already priced in.

If the financial system is truly to be restructured to eliminate the unbridled greed and conflicts of interest which imperil investors, one component of reform should be to eliminate any requirements that bonds be rated and paid for by the issuers.  A better system would be to have the rating agencies provide information to the investor community and get paid if their information proves valuable.  It isn't.  No sophisticated investor would pay to know what S & P, Moody's or Fitch thinks.  Therefore, the problem will eliminate itself.

Marko's Take

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