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The Power of Rating Agencies

There is no question that credit rating agencies wield a wealth of power when it comes to ranking the risks inherent to stocks, bonds, and securities, and the entities that issue them.

But given the financial crisis of 2007 that fueled nearly a half-decade of recession — and given that the top agencies were rating as some of the safest the exact pools of debt that helped prompt and drive the collapse — are we certain that these agencies are entitled to the power they hold?

Maybe not, analysts suggest, but the rarefied air that the Big Three — Moody’s, Standard and Poor’s, and Fitch — enjoy, it may not be dissipating yet.

“From what I see in the capital markets, ratings are as important as ever,” says Jack Chen, principal of Pronetik, a consulting firm that specializes in finance. “A rating agency downgrade on a sovereign credit can still make impact. A downgrade on a corporation’s debt ratings will still make that corporation's cost of financing more expensive.”

And so, has anything changed in the wake of the Great Recession? How much weight do the credit rating giants still throw around?

Some Change, or None: Rating Agencies Post-Crisis

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“Rating agencies have changed some of their practices,” says Chen. “[They] now publish their criteria on a much more frequent basis and publish other information required under [Securities and Exchange Commission] rules.

“As part of the post-credit-crisis financial reform, the SEC took the requirement of ratings out of its regulations,” he continues. “Doing so was meant to lessen the requirement … and thus the dependence on ratings, that had been built into the regulatory system.”

So, maybe some investors will conduct business in wiser ways, freed of the pressure to peg every move to triple-A ratings. But does this mean real change in the way ratings are applied?

Not so much, according to Chen.

A lot of the resistance to rethinking how the system works has to do with investors themselves. Chen notes that many still rely — and seem to want very much to continue to have access to — the same kind of ratings that they always have even if they led us down the path of the past five years. Investors may not be required by law to invest in bonds of a certain rating, but they still want the familiar scores for their own internal guidelines.

Ed Grebeck, a strategist in global debt markets and an adjunct professor at New York University (he tried to warn the financial world about flawed ratings in the run-up to 2007), says there has been some movement toward better practices.

“Asset-backed securities issuance volumes are way down, compared to pre-crunch 2007 highs,” he says, referring to securities much like the devastating mortgage-backed products of the last decade. “This is where Moody’s and S&P earned their biggest fees from ratings. In contrast, compare junk bonds, issued by real corporate distressed borrowers, whose issue volumes today exceed 2007 highs.”

It may be modest progress toward less ethereal products, but it’s a start.

“This tells me investors get it,” says Grebeck. “They prefer real bonds of borrowers, they can feel, touch, underwrite and sell if they have to, over complex hairy pools of assets subject to (Moody and) S&P ratings — which themselves are subject to conflicts — and which are illiquid.”

Accountability: Next Steps

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Here’s a problem, however. Enforcement of accountability, when it comes to the ratings agencies that beefed up the scores of the assets that failed so catastrophically — it’s not developing fast enough. Or so some analysts say.

“What we need is good third-party disclosure and investors with a basic understanding of how the market is supposed to work,” says Ann Rutledge, founding principal of R&R Consulting, an independent credit rating agency.

And agencies outside the Big Three should be instrumental in taking a look at the ratings as applied, she suggests. More agencies, demanding more justifications for the ratings such as those she says banks pressured rating agencies to over-enhance in the run-up to the mortgage crisis.

“This gray area about ‘it’s over-enhanced, it’s under-enhanced’ — this is a huge free lunch for Wall Street,” says Rutledge. “It’s the last free lunch, until we all change our platform.”

Her proposed strategy to change that “platform” includes a key component: transparency about methodology.

“Just go public with it,” she says, meaning: “‘We define triple-A, in the structured world, as meaning that on average you can expect to lose 3 cents’ … or whatever we decide it to be. And we set those levels for each credit rating and we make our methodology transparent.”

Think of it as standardizing the length of a foot measurement, Rutledge says. Rather than each “king” choosing their own subject’s foot to set the length, institute an open methodology for a common baseline when it comes to what is a triple AAA rating, a triple-B rating, and so on down the line.

“We have the Moody’s triple-A, we have the S&P triple-A, we have the Fitch triple-A,” says Rutledge. “And there’s not enough transparency around that to understand what the dollar-equivalency is.”

Agencies and analysts could then test the methodology if they suspect there’s something wrong with it. But if accountability is to move forward in the ratings agency world, policies can no longer exist behind a curtain for every agency that wants to issue them.