Why You Shouldn't Trust Ratings From Rating Agencies

By Ryan C. Fuhrmann | September 05, 2011 AAA
Why You Shouldn't Trust Ratings From Rating Agencies



Along with stock market investors, the credit ratings agencies have had a rough decade. The ratings agencies have encountered serious criticism over their fundamental role of providing ratings for the credit of corporations and government entities. That criticism has only increased in recent years and was further heightened recently as Standard & Poor's downgraded the United States from the highest AAA rating.

TUTORIAL: Basic Bonds

The ratings industry is dominated by three large players: Standard & Poor's, Moody's and Fitch. Their primary role is to rate the risk of defaulting on debt and other credit-related securities. The reach of these firms is vast. In its most recent annual report, Moody's stated that it has relationships with around 11,000 corporate issuers and 22,000 public finance issuers. But as McGraw-Hill, which owns S&P, pointed out in its most recent report, global regulators "have been reviewing the role of rating agencies and their processes and the need for greater oversight or regulations concerning the issuance of credit ratings." Below is an overview of why the review process shouldn't always be trusted by investors. (For related reading, see Bond Rating Agencies: Can You Trust Them?)

Conflict of Interest
A key criticism is that the issuers themselves must pay the credit ratings agencies to rate their securities. There are potential conflicts of interest with this model as the issuers want the highest rating possible to makes their securities more appealing to potential investors. A high rating can also lower funding costs. The alternative is to have investors and institutions pay for the ratings, but the ratings agencies have pointed out that there are also conflicts with this model as well. For instance, it could allow these investors to influence the ratings, as could the issuers.

Another key concern with the credit ratings process centers on a number of credit implosions ratings agencies have largely missed over the past decade. Back in 2001, along with most investors, the agencies were slow to catch on to the fact that energy giant Enron was hiding massive liabilities off of its balance sheet. Enron was eventually forced to declare bankruptcy and it wasn't until right before the company's demise that the agencies began to downgrade its credit ratings. Politicians, including Senator Joe Lieberman in a speech in March 2002, questioned how the agencies, with supposed inside information on Enron's inner workings, missed the hidden risks. (What is the overall lasting impact that Enron has had on the investment community and the country in general? For more, see Enron's Collapse: The Fall Of A Wall Street Darling.)

Despite the criticisms, it is admittedly going to be difficult for any party, be it a ratings agency or regulatory body, to detect fraud that a company is hiding. However, these parties have been much less forgiving on the ratings agencies for lack oversight on ratings for mortgage-backed securities (MBS) right before the housing bubble burst. A large number of these securities received the highest credit ratings, including AAA, but proved to be anything but safe.

Questions are Raised
The agencies rated thousands of collateralized debt obligations, or CDOs, which divided pools of securities backed by assets, such as housing mortgages, into tranches that were supposed to have differing payback risk. Risk levels varied from supposedly safe senior tranches to sub-prime pools, but even the highest rated securities ended up being downgraded to the lowest junk ratings as housing prices started falling and eventually dropped dramatically in the most speculative markets.

Troubles began surfacing in 2006 and picked up steam through 2008. Investigations of the ratings agencies have uncovered a number of potential conflicts of interest between the issuers and raters, confirming the worries of critics. The Credit Ratings Reform Act of 2006 was enacted to increase oversight of the ratings agencies, but many have felt it hasn't done enough to rein in their influence on securities markets.

The United States Downgrade
Industry criticism had died down a bit since the credit crisis and subsequent reform act, but recently picked up when S&P downgraded the debt of United States to AA+ from the AAA rating it held for more than 70 years. It immediately received fierce criticism from U.S. politicians as well as investors. Many have questioned if the United States deserves a lower rating than other countries like France, Belgium and New Zealand.

The U.S. Treasury also caught a $2 trillion arithmetic error when S&P allowed them to review its work prior to officially making the downgrade. S&P's decision was based on how politicians have handled the federal deficit and that an agreement on how to lower the deficit has not been reached. Again, criticism was widespread as the U.S. government is still seen as one of the most creditworthy public issuers in the world. (For related reading, see Why S&P Downgraded The U.S. And Others Did Not.)

The Bottom Line
Regardless of whether the ratings agencies truly failed in their roles of providing accurate credit ratings on a timely basis, most investors would be wise not to rely solely on their opinions. The agencies themselves are quick to point out their ratings are only opinions and, according to S&P, "should not be viewed as assurances of credit quality or exact measures of the likelihood of default." Instead, it advises users of its ratings to consider it a commentary on relative levels of credit risk.

In the end, investors must perform their own due diligence in determining the safety levels of debt and related securities. The opinions of the credit ratings agencies can help them get to a conclusion, but as events of the last decade illustrate, they can be just as off base as any other investor when it comes to the more extreme credit events. (For related reading, see The Debt Ratings Debate.)

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