Wall Street Journal Editorial on Ratings Agencies:
Pop quiz: If the government made this page required reading, would you expect our editorials to become more informative or less? For those puzzling over the answer, the government has helpfully run an experiment.
During the credit boom, investors struggled to understand complex new securities. So they relied on the credit ratings agencies, mainly Standard and Poor's, Moody's and Fitch. By labeling the new securities with the same ratings already applied to corporate bonds, these firms gave investors a handy frame of reference. Just one problem: The new securities had almost nothing in common with corporate bonds.
Most important, they didn't get repaid like corporate bonds. Drexel University finance professor Joseph Mason has examined Collateralized Debt Obligations (CDOs) and found that those receiving a Baa rating from Moody's were more than 10 times as likely to default as similarly rated corporate bonds. Moody's argues that the figure is closer to eight times, but you get the idea.
S&P recently downgraded or threatened to downgrade almost half the subprime mortgage bonds the firm rated in 2006 and the first half of 2007. Last year, S&P had to lower its ratings on more than $100 billion in home mortgage bonds and $100 billion in CDOs. Fitch has also botched estimates on tens of billions of dollars of securities. The problem is not new. Enron's debt was downgraded a mere four days before its bankruptcy filing.
Are the ratings agencies always the last to know, or just the last to acknowledge a problem? The agencies point out that they rely on facts presented by issuers, and that they are not responsible for conducting due diligence. In other words, if S&P and Moody's are asked to rate a pool of mortgage loans, they don't actually examine any of the individual mortgages within the pool. An S&P spokesperson tells us, "We are not auditors; we are not accounting firms." So if all the information about the assets underlying these bonds comes from the person selling them, and the credit rating agency never verifies any of it, investors might ask, what exactly does the rating agency provide?
An opinion. Sometimes called "the world's shortest editorials," credit ratings enjoy First Amendment protection and thank goodness are not subject to underwriters' liability. Just like other members of the media, credit raters have lately issued lots of opinions that turned out to be wrong. Of course, given the size of ratings fees, investors might have expected more than average journalism. Good reporting requires skepticism, even without a due diligence requirement. Moreover, a good journalist would have questioned whether historical mortgage repayment rates were any guide to a market that was changing so radically.
The established rating agencies are also paid by the issuers of securities they rate, so they need to take care in managing conflicts of interest. Some observers suggest that the subprime debacle occurred because Ph.D.s at investment banks got the better of this relationship and outsmarted the credit raters. Unsure how to evaluate new financial instruments, the rating agency staff, according to this view, accepted statistical models cooked up by Wall Street geniuses. Given that the investment banks pay more than the rating agencies, one would expect that Wall Street would attract more talent. Yet the smart guys running investment banks can't compete with the profit margins of the credit ratings firms.
S&P and Fitch are part of larger companies, but Moody's offers a clean look at the business. Until the recent downturn, Moody's had enjoyed annual growth in revenues and profits above 20% and operating margins above 50% for the previous five years. Such margins are extremely high -- better than Microsoft, Intel, Nike or Coca-Cola -- for a firm that is not even the market share leader in its industry. Analysts surmise that margins are similar at S&P and Fitch. We're thrilled that journalism can be so lucrative, but what is the secret sauce that generates such profits?
The answer is government help. S&P, Moody's and Fitch are designated by the SEC as "Nationally Recognized Statistical Rating Organizations" (NRSROs), which means that thousands of organizations require their services. Banks and brokerages that want to comply with net capital requirements have to hold assets rated by NRSROs. In most states, insurance companies have to hold assets in one of the four highest NRSRO-rating categories to avoid running afoul of regulators. Money market funds have to keep large percentages of assets rated highly by NRSROs. The government has licensed only a handful of firms to provide a service, and then requires investors, indirectly, to pay for it.
A 2006 law encouraged the SEC to approve more NRSROs and expand competition, and the agency is slowly doing so. On Monday the SEC approved LACE Financial, after recently giving the nod to Egan-Jones. Now would also be a good time to consider the other government-created distortion in this market: SEC Chairman Chris Cox, Senate Banking Chairman Chris Dodd and House Financial Services Chairman Barney Frank should discuss whether anyone's opinions should be required reading.
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