Over Rated?

The subprime fiasco has put corporate credit-ratings on thin ice.

Perhaps, some say, those armies of analysts aren’t needed at all. One dramatic solution: rely instead on quantitative market forces to determine appropriate bond ratings. It’s not science fiction. During his tenure at Moody’s, Fons claims he built an automated scoring model that accurately replicated rating-agency decisions. A key component of that approach is the market price of a corporate bond, which reflects the opinions of millions of investors and implies a certain level of creditworthiness.

To anyone aghast at the thought of letting market forces decide credit ratings, Fons points to a parallel example. “We have a functioning equity market without ratings,” he says. While acknowledging obvious differences between stocks that rise and fall with company performance versus bonds that require actual repayment, Fons nonetheless maintains that ratings supply a needless crutch. Investors “like a third party that can share the blame if things go wrong,” he says.

Blame Game

Things certainly have gone wrong, and blame has certainly been doled out. Regardless of the outcome, “it’s hard to believe that rating agencies, and bond ratings, will be held in the same esteem they enjoyed for years before this [subprime] episode,” says Richard Larkin, director of research for investment firm Herbert J. Sims and a former managing director at both S&P and Fitch. Adds Kaitz: “There’s nothing any regulator can do to make the credit-rating agencies more reliable; the only thing that will restore them is time — if they issue more-reliable ratings.”

Despite the criticism, no one expects the agencies to just fade away, least of all the investors who depend on the reality checks they provide. “I absolutely want to know what the rating agencies think of a bond — if it’s been upgraded or downgraded in the past, and what the trend is,” says Thomas Dalpiaz, a fixed-income portfolio manager at Advisors Asset Management.

“Moody’s and S&P have been around for over 100 years, and there have probably been [fewer] than 12 high-profile [corporate bond] disasters, with some of those based on issuer fraud,” says Rosner. He expects that track record to hold up, since “they’re generally using models that have been in place for a long time, based on a long history of empirical data.”

To some degree, the agencies may be less to blame than the rules that govern them. Case in point: an early 2008 downgrade for municipal-bond insurers also beat up the bonds they insure. Despite no material change in the bonds, says Larkin, they slipped below investment grade, and because SEC rules require money-market funds to hold only investment-grade assets, managers with such bonds in their portfolios had no choice but to sell. “There was a massive dislocation because suddenly everyone had to unload this paper, which wasn’t really in danger of default, simply because it didn’t meet the regulation,” says Larkin.

“Our own rules may be contributing to an uncritical reliance on credit ratings as a substitute for independent evaluation,” acknowledged SEC chairman Christopher Cox. “That should be neither the purpose nor the effect of any SEC rule.”


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