Insight: Credit of the big three under fire

The credit crisis has raised the profile of the rating agencies and the possible role they played in creating the current mess.

They have been criticised for the accuracy of their ratings and have been accused of facing conflicts of interest because they are paid by the issuers whose securities they rate.

Unfortunately, it has become apparent that many investors and most pundits do not understand what ratings mean and how the agencies work.

First, some necessary background. Ratings reflect credit risk, that is, the ability and willingness of a party to repay a debt. They imply nothing in terms of liquidity, potential for appreciation or volatility. Thus, an investment decision based only on ratings is misguided.

Essentially, there are only three main rating agencies: Standard & Poor’s, Moody’s and Fitch. All three rate bonds using a nine-category scale which they label differently. S&P and Fitch go with: AAA, AA, A, BBB, BB, etc, while Moody’s chooses: Aaa, Aa, A, Baa, Ba, etc.

Most people think that AAA/Aaa means foolproof, BBB/Baa denotes something riskier, and CCC/Caa spells trouble. Reality, however, is more complex. First, there are many ways to measure credit risk; and second, S&P and Moody’s do employ different approaches to measure it. Thus, they attribute different meanings to seemingly “equivalent” rating categories.

Now, the confusing part: S&P rates are based on default probability. For example, a 10-year collateralised debt obligation bond with a BBB rating reflects a 7.1 per cent default probability. Moody’s goes by expected loss. Expected loss, to make things more challenging, is calculated as default probability multiplied by severity of loss.

So, what can we conclude from these observations? Well, although ratings imply an objective standard (in terms of default probability or expected loss) that in itself is meaningless. The key thing is the set of assumptions behind the analysis. Some of these assumptions are sound, others less so. Hence, taking a rating at face value (unaware of the assumptions behind it) is unwise.

The agencies differ not only on the definition of each rating category, but also on the computational methods used for their analyses. Therefore, there is no reason to expect a one-to-one correspondence between Moody’s and S&P ratings. In practice, however, the degree of agreement, category by category (AAA and Aaa, etc), is extraordinarily high. This degree of agreement seems strange.

Finally, the crucial point: the rating agencies enjoy a power that goes beyond what regulators probably intended and, even worse, understand.

Whether a bond gets an investment-grade rating or not is critical. In some cases this prevents certain investors from buying the bond; in others, it forces the holders of the bond to sell it.

Therefore, what is frightening is not only that the agencies determine if the bond meets the BBB/Baa standard or not, but also the fact that they define that
standard.

Granted, these issues might sound arcane. But grasping them fully is an essential requirement for any enlightened conversation aimed at improving the current environment.

At the very least, the following topics should be addressed:

●The fixed income markets are global in nature; who should oversee the rating agencies – a US regulator or an international entity?

●What should the regulator regulate? The right of an agency to exist? Or the methods of analysis employed?

●Are the rating agencies truly independent from one another?

●Under the current regime, is it safe to determine capital requirements based on
ratings?

●Should the regulator specify an objective and common standard to measure credit risk and let the agencies map their ratings onto this scale?

Dealing with these issues is the only path to intelligent regulation. But one final point. The rating agencies do play a necessary role: replacing them by a government entity would be a tragedy.