In the depression-era 1930s, when credit worthiness was all that mattered, American government bonds were rated AAAAA—as if the more letters you attached to a borrower, the safer they would seem. In more recent times, the triple-A designation has done the trick. Whether attached to government debt, federal agencies or the strongest corporate borrowers, it has stood as a gold standard among ratings, lowering borrowing costs and reassuring creditors.
During the 1980s and 1990s, scarcity only enhanced its standing. The number of companies issuing such high-grade debt dwindled, as corporate-finance theory encouraged companies to borrow more heavily to increase earnings. According to Standard & Poor’s (S&P), a rating agency, only six American non-bank companies carry a triple-A rating today, including Berkshire Hathaway and General Electric.
But the rating is coming in for some stick from politicians and pundits alike, because it has cropped up in connection with that most unsound of loans, subprime mortgages. These are anything but triple-A, but can be repackaged into securities via collateralised debt obligations (CDOs) in a way that makes default an extremely low mathematical probability. In the process, such ratings have made the agencies a great deal of money. Moody’s, for example, made more than 40 percent of its revenues from rating structured products such as CDOs last year.
Marc Dann, attorney-general of Ohio, is investigating whether, in his words, the ratings agencies took part in fraud by bestowing triple-A ratings on structured products created out of subprime loans. Bill Gross, a fund manager at PIMCO, a bond-trading firm, likens the highest-rated tranches of CDOs to a Hollywood madame masquerading as a wholesome, all-American girl.
The ratings agencies are holding their ground. Cliff Griep, the chief credit officer at S&P, argues that ratings attempt to address only creditworthiness, not market risk, and are driven by fundamentals, not fluctuating prices.
But the questions being asked of the agencies are important because banks around the world have been filling their vaults with AAA-rated structured products ahead of international implementation of the Basel 2 regulations on bank capital. Under this new accord, a bank holding triple-A assets is allowed to keep less capital, enabling it to lend more. So banks have stocked up, especially on CDOs. If they were forced to sell securities that had been downgraded, liquidity could dry up.
No one knows for sure what would happen to the value of the triple-A tranches in such a scenario. In this week’s ratings downgrades, the highest-quality tranches of CDOs were unaffected.
But the agencies are caught in a dilemma. They know that if the cherished triple-A rating is seen as devalued, it would undermine their credibility. Yet they earn so much revenue from CDOs that working with the banks and funds that structure them has proved irresistible.
Some analysts argue that it would make sense to alter the labelling. John Mauldin, who writes a popular financial newsletter, argues that the ratings agencies should have created a new type of standard, using numbers like “CDO rank 1-10”. That way a triple-A mark would still stand for a port in a storm.