The Ratings Game - A Solution

By Andrew Beattie | July 30, 2010 AAA
The Ratings Game - A Solution

If a bond falls unrated to the market, can anyone buy it? This is a question that investors may have to face now that the Securities and Exchange Comission (SEC) will have powers to hold ratings agencies accountable for their ratings - meaning that investors who lose on one of the official ratings can potentially sue the rater. We'll look at the current controversy, as well as a possible solution.

IN PICTURES: 8 Ways To Lose Money On Bonds

Poor Me
It is difficult to sympathize with the ratings agencies. They've had it their way for a long time. Because the government required their ratings on any issue to common investors, and only recognized certain agencies, they enjoyed a legislated monopoly with no legal downside. Their rebellion is no different, in that sense, than a strike by public employees.

Self-Serve Investing
Now the SEC is being pushed into a corner by their own rules requiring a rating on bond issues. Do they let bonds be sold to investors without a rating?

For investors, this would mean doing their own due diligence as they would for a stock - in many cases the same diligence. Take Ford (NYSE:F) - the only American car company that isn't in government daycare - as an example. Ford's fundamentals, as a stock, look good, including its cash on hand to pay its debts. Should Ford issue a bond, its working capital ratio and other fundamentals would be as important to any buyer of the bond as it is to any buyer of the stock. If you can analyze a stock, you can analyze a bond.

Anybody's Game
The SEC's concern over investor's inability to take personal responsibility for their portfolios is what led to these few ratings agencies gaining this coveted post. There is a simpler solution than the "unreasonable" expectation that an investor should think for him or herself. Break the monopoly and let merit sort it out. (Learn how SEC was formed, and other important events that shaped financial regulation, see The SEC: A Brief History Of Regulation.)

The Analyst System
In fact, stocks have been operating under a similar system for, well, forever. True, there are institutional analysts that have huge followings of investors – and some of them are well worth the attention. However, after the dot-com bubble, it became clear that being institutional occasionally meant having the word "sell" surgically removed from one's vocabulary.

There are, however, non-institutional freelancers, including the writers of private, subscription-based investment newsletters and even free articles. Newsletter-style analysts are plentiful, and investors who subscribe can always cancel if the advice is not worth their fee - natural selection and accountability all in one. With free analysis, there is no fee. Any type of analysis should always be taken with a grain of salt - as the MBS debacle has shown, even when it comes from accredited raters - but when you find someone you trust, you tend to follow what they write. Even with free analysis, the same selective pressures - page views, whether monetized or not - are at work. (Check out Market Crashes: The Dotcom Crash.)

Why Not Bonds?
Does the SEC really think a bond issue could hit the market with no one expressing an opinion? Not likely. When one of our analysts suggested that, god forbid, Apple (NYSE:AAPL) may be overpriced at P/E of almost 20 and a product line that, to him, looked like the same damned thing in different sizes, we had no shortage of helpful opinions pointing out strengths in Apple's favor as well as some questioning his intelligence. This was unsolicited analysis of an analysis. It is very doubtful a first run bond would go to market without someone weighing in.

Moreover, the quality bond analysts would find a greater demand for their opinion based on success - a stark contrast to the SEC model that holds a gun to raters as the price of failure and simply offers the ability to continue as the reward for success.

Rather than increasing regulation and upping the stakes, it would be more efficient - and much cheaper - to decentralize bond rating. Investors are smart enough to sift through opinions and pick one they trust. What if they get burned? They move on having learned a lesson about depending on that analyst or, better yet, they learn to do their own research.

The Bottom Line
On the sum, the price of giving over responsibility is much higher than taking it on. The wealth of an investor dwindles with every tax-funded regulator needed to watch the raters. The returns of their investments also shrink, as every dollar a company pays in higher than market fees to the rating cartel is a dollar less for its investors. Sure, investors can lose money. But that's a very real risk even with the SEC looming above the raters' heads.

Investors would be better off buying investments because they've researched them themselves, rather than depending on a ratings agency's rubber stamp. Instead, we are likely to have the raters demanding higher fees to offset the legal risk, and the SEC adding staff in anticipation of tracking every security rating from here to eternity - neither of which will help you as an investor, nor encourage you to become a better one. (Learn more in When Financial Regulators Let You Down.)

Catch up on your financial news; read Water Cooler Finance: The Unrelenting Claw Of Bernie Madoff.

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