The effectiveness of the debt rating system is a hotly debated subject. This issue was never more clear than during the subprime crisis of 2007, which revealed the system's flaws when highly-rated structured securities were suddenly revealed to be of very questionable value.

The loans supporting these structured securities were made to marginally qualified borrowers and were often backed by very inadequate collateral, yet did not result in significant downgrades from ratings agencies. Some questions have been raised as to whether this could have been a result of a potential conflict of interest and/or a lack of competition in the industry. Here we'll take a look at ratings agencies and at why critics contend ratings may be suspect, particularly for structured securities. (To learn more about the subprime crisis, see our special Subprime Mortgages feature.)

Ratings and Structured Securities
When an individual invests in a fixed-income security, he or she is essentially loaning money for a promise of scheduled, fixed-interest payments and the eventual return of principal when the loan matures. An investment in this type of security involves a risk that the company might not do well enough to pay the agreed-upon interest on the scheduled dates. There is an even greater risk that the company will not be able to return the principal borrowed when the security matures.

To help investors assess these risks, ratings agencies such as Standard & Poor's and Moody's analyze and rate companies and the fixed-income securities they issue, to determine the likelihood that they will default on their loans. (For more insight, read What Is A Corporate Credit Rating?)

When house prices dropped during the subprime meltdown, the value of much of the subprime home-mortgaged property dropped below the principal values of the home mortgages. As a result, the collateral for the home mortgages provided no collateral for the structured securities. Critics suggest that the rating agencies should have accounted for this risk in their ratings, particularly when it had been known that many subprime mortgagors were marginally qualified for the home loans they received.

Lack of Competition
According to a report published by the Basel Committee on Banking Supervision in 2000, there are about 150 credit rating agencies worldwide. However, only a handful of these companies are nationally recognized as major players called Nationally Recognized Statistical Rating Organizations (NRSRO). NRSRO ratings are what the Securities and Exchange Commission (SEC) relies on when determining whether a particular security must be registered. In light of this relative lack of widespread competition, the issuers may appear to be under pressure to cooperate with the big rating agencies. (To learn more securities, read Policing The Securities Market: An Overview Of The SEC.)

A poor rating can result in a substantial financial detriment to the issuer of the security. Because of the impact of a given rating, the companies issuing the securities are under severe pressure to treat rating agencies favorably. With so few players and so much riding on the rating bestowed on the security, it may be possible for rating agencies to become involved in or threatened by conflicts of interest. Another concern is that the debt rating industry is dominated by three companies: Standard & Poor's (S&P), Moody's and Fitch; S&P and Moody's together held over 75% of the market in 2007. This market dominance may give these large agencies more influence.

Credit Rating Basics
Ratings agencies are a vital part of the securities market. Their ratings greatly influence the fixed-income markets; markets react, often dramatically, to the increased or decreased likelihood of default when a rating changes. Additionally, for the debt-issuing company, a high rating may translate into hundreds or thousands of dollars in savings in interest payments and registration fees. A company with a high rating given by an NRSRO can issue certain commercial paper that is exempt from registration with the SEC, but also relieved of registration under the Uniform Securities Act. (To learn more about debt ratings, read Why Bad Bonds Get Good Ratings.)

Ratings range from the highest credit quality (insured securities) to the lowest credit quality (securities in default). Long-term bonds and structured debt are rated using an "ABC" system. Triple A ('AAA' for Standard & Poor's, 'Aaa' for Moody's) reflects the highest credit quality, and 'C' (Moody's) or 'D' (Standard & Poor's) reflects the lowest quality. Within this range, there are varying degrees to each rating.

Moody's adds numerical modifiers 1, 2 and 3 to each generic rating classification from 'Aa' through 'Caa'. 1 indicates that the obligation ranks in the higher end of its generic rating category, 2 indicates a mid-range ranking and 3 indicates a ranking in the lower end of that generic rating category. Standard & Poor's ratings may be modified by the addition of a "+" or "-" (plus or minus).

Figure 1, below, provides an overview of the different ratings symbols that Moody's and Standard and Poor's currently issue and have been issuing for many years:

Moody\'s S&P Definition Notes
Aaa AAA Highest Rating Available Investment Grade
Aa AA Very High Quality Investment Grade
A A High Quality Investment Grade
Baa BBB Medium Risk Minimum Investment
Ba BB Low Quality/High Risk Below Investment Grade
B B Very Speculative Below Investment Grade
Caa CCC Substantial Risk Below Investment Grade
Ca CC Poor Quality/Highest Risk Below Investment Grade
C D In Default Below Investment Grade
Figure 1: Moody\'s and Standard & Poor\'s debt rating systems

A Real or Potential Conflict of Interest
The rating companies receive their compensation from the companies whose structured securities they rate. As a result, ratings company critics suggest that the fact that the ratings companies obtain fees from the companies that issue structured securities may make the ratings agencies susceptible to issuing artificially high ratings. In addition, the rating agencies may become reluctant to downgrade the securities of firms they were involved with for fear of losing future business. This sense of loyalty is thought to have played a large part in the meltdown of the subprime mortgage industry. Some critics have said that not only did ratings agencies give speculative investments higher initial ratings than would seem warranted, they were also slow to downgrade them. (For related reading, see Who Is To Blame For The Subprime Crisis?)

Some ratings agencies also advise issuers on structured debt securities and then rate the securities they helped structure, which many believe to be a questionable business practice leading to inflated ratings.

On the other hand, charging the issuers a rating fee may be more beneficial to the public because under this system, the public has open access to the rating information, whereas if the system put the burden of payment on individuals, they would have to pay for the right to see the ratings, reducing public access to this information.

Federal Intervention
The issue of conflict of interest, or the appearance thereof, has led to so much criticism that in 2008, the SEC began an investigation to determine whether the ratings agencies were "unduly influenced'' by issuers and the investment banks selling structured securities.

In response to the criticism, and perhaps spurred by the SEC investigation, debt rating agencies proposed changes in the way structured securities are rated in order to help distinguish them from less complex investments such as corporate or Treasury bonds and to make it more clear that structured securities do not have the same risk characteristics as similarly rated corporate securities. The International Organization of Securities Commissions (IOSCO), which is regarded as a forum for securities regulators, also proposed the creation of a code of conduct prohibiting debt rating agencies from providing advice on debt instruments for which they provide ratings.

This potential conflict of interest created by a rating organization being paid by the companies whose securities they rate may be parallel to the potential conflict of interest situation that existed when stock analysts employed by brokerage firms were issuing favorable reports on securities that were underwritten by the investment banking side of those same brokerage firms. Because of this, rules were promulgated that required a separation of functions. For example, FINRA rule 2711 and NYSE Rule 472 require that those performing research do not supervise and are not to be supervised by anyone in the same firm's investment banking department and, perhaps more importantly, that no member may pay any bonus, salary or other form of compensation to a research analyst that is based on a specific investment banking services transaction. (To learn more, read The Chinese Wall Protects Against Conflicts Of Interest.)

The Bottom Line
Credit rating agencies are under scrutiny and the subject of substantial criticism. Until the conflict of interest issues are squarely addressed, it is likely that the criticism will continue and the matter will remain in turmoil.