Remember those Lehman bonds that caused the Reserve money market fund to break the buck? How about all of those states that have struggled to balance their budgets? And let's not forget those mortgages (millions of them) that have fallen into foreclosure, dragging down the special investment vehicles that were created through securitization and marketed as safe, conservative investments. The commonality between all of these disappointments is that bond rating services, including industry giants Moody's Investors Service, Standard and Poor's and Fitch Ratings, certified them as solid, creditworthy investments. Now, the ratings services are being called on the carpet for their misdeeds by legislators and customers alike. This could be bad news for the big bond raters. (Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point. Find out more in Bond Rating Agencies: Can You Trust Them?)

Rating the Raters
At the one end of the spectrum, Congress is looking into allegations that Moody's intentionally issued misleading ratings. The investigation is being spurred on by an ex-credit analyst and the ex head of Moody's compliance team. The analyst, Eric Kolchinsky has come forward with specific and damaging allegations that accuse Moody's of issuing high ratings from complicated debt securities when the firm was in the process of downgrading the underlying investments. The ex compliance chief claims that Moody's provides ratings on tens of thousands of municipal bonds that it doesn't monitor.

The Securities and Exchange Commission (SEC) is also taking a look at the situation. The SEC has proposed greater disclosure of the firm's ratings practices and hope to encourage additional ratings agencies to enter the business.

Crash Backlash
Scrutiny from legislators isn't the only trouble brewing for the rating agencies. Backlash from the credit market crash has insurance regulators looking to find a better way to vet bonds. The insurance industry relies heavily on the bond raters and holds some $3 trillion worth of bonds the agencies have rated. These bonds generate the revenue that will be used to fund payouts for a variety of insurance policies. Unfortunately, some of the ratings on those bonds have been less than accurate, resulting in billions of dollars worth of losses for investors and forcing insurance companies to ante up $2 billion in 2008 to prove to industry regulators that they could still fund the policies they have issued in the aftermath of the losses they took on their bonds.

Fighting Back
The companies aren't happy about the situation. The National Association of Insurance Commissioners (NAIC) is now considering the use of other sources of research to vet bonds in its members' portfolios. When their biggest customers are unhappy, the ratings agencies should be worried. (Don't want to be a passive investor? Discover how investment clubs allow you to take control of your portfolio, in Get Active, Join a Club!)

In an ideal world, the downstream impact of all of all this attention should be better ratings and greater safety for investors. In reality, the situation is likely to just get more confusing and more expensive as a ratings system that has been in place for decades undergoes a shakeup and yet another scandal takes its place in the record book.

Related Articles
  1. Investing

    Why Is Financial Literacy and Education so Important?

    Financial literacy is the confluence of financial, credit and debt knowledge that is necessary to make the financial decisions that are integral to our everyday lives.
  2. Budgeting

    Key Questions to Ask Before Moving in Together

    Moving in together is a big step. Here are some key financial questions to ask your partner before you make the move.
  3. Professionals

    10 Must Watch Documentaries For Finance Professionals

    Find out about some of the best documentaries that finance professionals can watch to gain a better understanding of their industry.
  4. Stock Analysis

    The Biggest Risks of Investing in Berkshire Hathaway Stock

    Learn about the risks of investing in Berkshire Hathaway. Understand how issues of succession, credit downgrade risk and increased regulation could hurt it.
  5. Stock Analysis

    Why Is GE Selling Some of Its Subsidiaries?

    Learn why GE is selling off a substantial amount so it does not have to comply with increased government regulation in the wake of the 2008 financial crisis.
  6. Investing

    Ideas for Your Bond Portfolio When Rates Rise

    It has been nearly 10 years since the Fed last raised interest rates, and though the central bank didn’t hike rates this month, they look to be coming.
  7. Economics

    How Does the Puerto Rican Debt Crisis Affect the US?

    Learn about the specifics of the Puerto Rican debt crisis and why economists disagree on how significantly it could affect the United States.
  8. Professionals

    Holding Out for Capital Gains Could Be a Mistake

    Holding stocks for the sole purpose of avoiding short-term capital gains taxes may be a mistake, especially if all the signs say get out.
  9. Credit & Loans

    Co-signing a Loan? Make Sure You Know The Risks

    Contractually, co-signers are just as responsible for the loan as the person actually borrowing the money. Be careful not to put yourself at risk.
  10. Investing

    Why High Yield Still Has A Role To Play

    An asset class of this bull market has been high yield debt, as many searching for income in a low-rate world have turned to these higher-yielding bonds.
  1. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  2. How can I use the funds from operations to total debt ratio to assess risk?

    The funds from operations (FFO) to total debt ratio is used in fundamental analysis to determine a company's financial risk. ... Read Full Answer >>
  3. How stable are municipal bonds?

    Stability is relative in the municipal bond market. Municipal bonds tend to be safer than many other types of investments, ... Read Full Answer >>
  4. Do negative externalities affect financial markets?

    In economics, a negative externality happens when a decision maker does not pay all the costs for his actions. Economists ... Read Full Answer >>
  5. Where can I find information about corporate bond issues?

    Information about new and existing corporate bond issues is published regularly in financial newspapers, such as The Wall ... Read Full Answer >>
  6. Why are high yield bonds typically lower rated bonds?

    The term "high-yield bond" is a bit of a misnomer. It is not the case that high-yield bonds tend to be lower-rated; instead, ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!