Why the Ratings Agencies Should Fear Congress

There was a lot of bashing of the ratings agencies this morning at the Portfolio

subprime panel. It was timely, coming as it did ahead of Congressional hearings

on the ratings agencies and their role in the present mess. Investors and lawmakers

seem to be losing faith in the the ratings agencies – but it’s the latter

which the agencies should fear more, not the former.

The Wall

Street Journal says today that "if worries persist, ratings could be

viewed as less valuable, and issuers may become less willing to pay firms to

rate their bonds". But in reality, so long as the present regulatory regime

remains in place, the issuers essentially have no choice but to pay

firms to rate their bonds. The universe of bond investors is dominated by large

institutional investors who have a mandate to invest only in bonds with a certain

rating – and so long as those mandates exist, the ratings agencies will

continue to have a license to print money.

What’s more, a whole new universe of creditors is going to become very ratings-sensitive

in a few months’ time, as the long-awaited Basel II capital-adequacy regime

gets implemented across the international banking system. The amount of capital

that banks are required to hold against any given loan will now be a function

of the debtor’s credit rating – giving banks every incentive to lend to

highly-rated weak companies rather than stronger, lower-rated entities.

Is that possible? Can a highly-rated company really be more likely to default

than a credit with a lower credit rating? Yes:

According to Moody’s, corporate bonds rated Baa (their lowest investment

grade) had a 5-year average default rate of 2.2% over from the period between

1983 and 2005. However, CDOs with the same Baa ratings suffered 5-year default

rates of 24%. Investment grade corporate bonds and investment grade CDOs are

not the same, and a CDO with a borderline investment grade rating is really

the equivalent to a junk bond.

If you look at Baa-rated municipal bonds, the difference is even larger: the

default rate on Baa-rated munis was actually just 0.09%, according to one of

the panelists this morning. "There can be a 250x difference in the probability

of default for this given Baa rating," he said.

So it’s not the investors that the ratings agencies need to worry about: it’s

the regulators. If they stopped requiring pension funds and the like to invest

only in bonds with a certain rating, then demand for ratings would surely plunge.

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