A primer on credit rating agencies

A primer on credit rating agencies

February 13th, 2013 By Chris Hopkins in Business Diary

Chris Hopkins

Photo by Contributed Photo/Times Free Press.

Last week, the U.S. Department of Justice filed a lawsuit against Standard and Poor's Financial Services. The action seeks $5 billion in damages and alleges that S&P defrauded investors by misrepresenting the credit risk on mortgage-backed securities. The default of many of these securities was a precipitating factor leading to the financial crisis. Attorneys general from several of the states are likely to follow suit (so to speak). So just what do S&P and its competitors actually do?

Standard and Poor's is one of just nine specialized financial companies that estimate the risk of certain investments in order to provide potential investors with more complete information before they invest. These nine firms hold a special and distinctive federal designation known as Nationally Recognized Statistical Rating Organizations (NRSROs).

This segment of the financial industry reaches back to 1909, when John Moody issued the first publicly available bond rating. All three of the major players (S&P, Moody's and Fitch) trace their roots to the early 20th century. These three behemoths currently issue 93 percent of all bond ratings.

Traditionally, the credit rating agencies like S&P employed financial analysts to assess the credit risk of bonds issued by corporations, municipalities and sovereign governments. While not perfect, a top-notch AAA rating from S&P could generally be relied upon as an affirmation that the company or city in question was extremely likely to fulfill its obligations to bondholders. Conversely, a CCC rating implied a high level of risk and signaled to investors that caution is warranted.

Originally, opinions issued by the rating agencies were paid for by investors seeking sufficient information to evaluate potential investments. In the 1970s, the model shifted and bond issuers (the companies and municipalities selling the bonds) began paying the rating firms to cover their bonds, setting the stage for a monumental conflict of interest.

Enter the mortgage crisis. Fannie and Freddie, followed closely by the Wall Street banks, bundled hundreds of home loans into pools that could be diced up into pieces and sold off, subject to ratings from one of the NRSROs. Rather than perform an analysis of each mortgage in the pool, S&P, Moody's and Fitch applied statistical modeling techniques to create their ratings. And the pressure was on to bestow the coveted AAA crown.

We now know that the models incorporated disastrously flawed assumptions and that over 95 percent of the investment-grade ratings were ultimately downgraded to junk status.

The basis of the civil action is the assertion that S&P succumbed to the conflict of interest and knowingly awarded undeserved ratings. It is interesting that none of the other agencies has so far been targeted by the government even though some were clearly following the same playbook. Also interesting is the fact that only S&P took the action of downgrading the U.S. Treasury last year.

The rating agencies provide valuable information for investors when they focus on individual companies and governments. The courts will decide if they crossed the line in getting paid to lend their imprimatur to the subprime monster.

Christopher A. Hopkins is a Chartered Financial Analyst and a vice president at Barnett & Co.in Chattanooga.