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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Sovereign Debt Crisis Threatens To Take Down World Economy

First we had countries which fell under the acronym "BRIC" - Brazil, Russia, India and China.  These countries were believed to be the emerging world powerhouses.  Now, we have a new one:  "PIGS", or Portugal, Italy, Greece and Spain.  In the case of PIGS, the acronym is not in the least flattering.  Rather, it refers to a group of countries in such financial trouble that their sovereign debt is threatening to pull down the European Union (EU) and possibly the global economy altogether!

The sign that major stresses can be felt is being witnessed in both the bond markets and the countries'
"Credit Default Swaps" (CDS), which price the "insurance" against default.  Recently, Spain's and Italy's bonds have carried a CDS of 1.65%, Italy's have risen above 1.5%, while Greece's have expanded to a frightening 4%.  To put things in perspective, the United States, no longer considered a great credit, has an active CDS market priced at less than 0.5%!  Ireland, not officially a PIGS country, but guilty by association, has its CDS in the 1.5% range.

About six weeks ago, I wrote a piece on Soverien Debt (http://markostake.blogspot.com/2009/12/investing-in-soverign-debt-much-riskier.html.  Reading this might provide some excellent background for anyone unfamiliar with the issues.

According to a recent article in the Wall St. Journal, the global economic downturn and extensive government spending to fight it, have led to major fiscal problems in Europe, especially for less-dynamic economies like Greece, Portugal, Ireland and Spain.  Such countries took advantage of their membership in the 16-nation euro-bloc during the boom by borrowing at unusually low interest rates.  But now, investors are worried about how they will reduce yawning budget deficits that exceed 12% of their economic output in the case of Greece and Ireland.

European policy makers are trying to pressure countries like Greece into taking stronger action to fix their finances. 

The potential damage from any sovereign default in the EU will affect the entire region which shares a currency but NOT fiscal policies.  Now there is talk that Greece is looking to be "bailed out".  Wonder where I've heard the words "bailed" and  "out" before?

The sovereign debt isssue is another reason that 2010 is shaping up to be one nasty year!

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Marko's Take