What Value Do the Rating Agencies Provide – If Any?

In the early 1900’s investment information was scarce and you needed to be in a “financial hub” to learn what was needed to make an intelligent and informed decision. After all, at this time the telephone was only 25 years old and the first coast-to-coast telephone call was not made until 1915. Silent movies in 1926 were the venue of choice. About the same time, several credit rating agencies came in to being, Moody’s in 1909 publishing the Manual of Railroad Securities, Standard Company in 1916, Fitch in 1920, and Poor’s also in 1920. Standard and Poor’s eventually merged in 1941. The value of the information provided by these companies was valuable because they could investigate the stock companies and spread the word quickly in a standard format for all subscribers to use. The information was so valuable; the investor paid a subscription price to receive the ratings.

The ratings worked well and informative. They worked so well, in 1936 the Comptroller of the Currency decided that banks must use the ratings as an independent source to determine the risk level of their own investments. Banks were not allowed to buy or hold any security below investment grade. The investment grade standard has since woven itself into numerous investment guides as a critical quality measure including retirement plans.

Much has changed over the last 100 plus years. Financial information is universally available to nearly every corner of the globe. The progress of information dissemination even changed the way in which the rating agencies charge for services. Since the 1970’s the insurer pays for the rating, not the investor, because the investor was able to spread the information through photocopying. This resulted in reduced revenues for the rating agencies due to fewer clients. Today, financial opinions are readily available, plus the information to form opinions is accessible through numerous high quality sources. The rating agencies have found themselves in a constant catch-up mode with information that can reach every investor in minutes.

Where is the value? The value in the rating transitioned from timely historical reporting to a qualified opinion about the future and possible outcomes. How have the rating agencies done in this new environment?

Enron was not the rating agencies finest hour. The company had an investment grade rating right up to four days before Enron filed for bankruptcy protection. In July 2007, Standard & Poor’s adjusted the rating methodology at the request of Goldman and UBS; so much for independency. Interestingly, the mortgage credit crisis went into full free fall when the credit rating agencies had investment grade status on the toxic mortgage instruments. Again, not a great moment for them. The missteps have become so frequent that much of the investment market is reducing the importance of their opinions.

When the U.S. Treasury was downgraded last year the market generally ignored the move as prices increased and yields were reduced meaning the perceived market risk had gone down, not up as reported by the rating agencies. More recently, the European Union has voted to curtail the use of the ratings by 27 members. Danish banks have fired Moody’s while Swedish banks have accused the agencies of being backward looking. Interestingly, several of the recent downgrades of European banks by the agencies have resulted in higher bond prices and lower yields just as the case with the downgrade of U.S. Treasuries last year. Under investigation by the EU, is making the rating agencies liable for incorrect information that results in a financial hardship for the rated enterprise.

Maybe the rating agencies never were able to make the transition from historical / current reporting to forward looking? The speed with which information moves today requires a view into the future of many informational services. Investors can read and learn about history and current activities as well as the next person. An informed and qualified opinion about the future is what is valuable. Maybe the rating agencies have become part of history and deserve a below investment grade rating?

 

By | 2012-05-29T11:28:57+00:00 May 29th, 2012|Categories: Money Basics|0 Comments

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