Bond Raters On The Rocks

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!)

Conclusion
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.

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