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Are Ratings Firms Trustworthy?

MCO PJC

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To add to the troubles of Standard & Poor’s (S&P), fellow ratings firm Moody's Corp. (MCO - Analyst Report) have cut the debt rating of its parent company The McGraw-Hill Companies, Inc. by two levels -- to Baa2 from A3 -- on Valentine’s Day, and has said it may reduce it again.

In November 2012, Mc-Graw Hill sold its education arm to Apollo Global Management, LLC (APO) for $2.5 billion. Subsequently, it has not included results from its education unit in its financial results and reported losses of $216 million in the fourth quarter. The new rating from Moody’s takes into account the sale of McGraw-Hill’s education arm as well as the civil lawsuit filed against the company by the Department of Justice.

The US Department of Justice has recently filed a $5 billion civil fraud case against S&P. Its parent McGraw-Hill has lost more than 20% since the beginning of the month, wiping out $3.75 billion of market value. Yields on $800 million worth of outstanding bonds have risen by as much as 0.9% since the lawsuit was filed on February 5. Clearly, Standard and Poor’s fortunes have been grievously affected by this development.

The first ever against a credit rating agency, the major accusation of the lawsuit is that the agency provided inflated ratings on $5 billion worth of mortgage related securities and misled investors. The incentive in this case was hundreds of millions of dollars in ratings fees which were paid by the issuers of these securities. Precisely, S&P assigned these ratings in pursuit of lucrative ratings fees and higher market share.

However, according to an analyst at BTIG, LLC, Moody’s also faces the risk of similar litigation in the near future. This may also have provided S&P ideas for a “similar announcement” shortly, the analyst opined.  Moody’s shares had taken a hit right after it was leant that rival S&P had been served a civil lawsuit. Share prices had declined even though Moody’s posted a 66% jump in net profit in the last quarter of 2012.

Many commentators have cited the faulty model of the ratings industry as the source of all its ills. The issuers of debt instruments select ratings companies to rate their securities and pay them ratings fees. These fees had touched $150,000 for rating a residential mortgage-backed security and $750,000 for a synthetic collateralized debt obligation.

Even the Justice Department’s lawsuit points out that this was the primary reason for the ratings firms’ conflict of interest. Ratings are crucial for the buyers of such instruments, but fees are received by ratings firms from issuers, an inherent contradiction.

The Dodd-Frank legislation seeks to replace this system wherein the Securities and Exchange Commission (SEC) would set up an independent board which would select which ratings agencies would rate a particular class of asset-backed securities. Following this, the system would be expanded to ratings of all debt securities.

Further, the SEC could create different certifications for rating different kinds of debt and prevent ratings firms from issuing ratings on more than one category. This would encourage competition and the entrance of new players.

An analyst at Piper Jaffray Companies (PJC - Snapshot Report) has taken a contrarian view of things, citing “manageable litigation risks.” He further added even after four years of an exhaustive search, “the ‘smoking gun’ that would prove fraud has failed to materialize.” The analyst then went on to recommend that investors purchase stock in both McGraw-Hill and Moody’s, saying there prices may increase appreciably in the future.

What cannot be ignored is that S&P was analyzing subprime mortgage data that was also accessible by the rest of the market. In fact, the securities which the Justice Department has held up as an example received near identical ratings from other ratings firms. S&P also cut ratings of several mortgage-backed securities in 2007. It also issued warnings about the housing market situation.

Thus, it could also be argued that the entire financial risk management system could not correctly evaluate the decline that was to come. This is what slowed down S&P from acting, though it cut ratings earlier than its industry rivals. Unless far reaching systemic changes are rung in, this could only be a temporary hiccup for ratings firms. However, there long term future seems undisturbed.  

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