AAA Ratings Problem, where’s the trust?

by Erin McCune on January 7, 2009

in Credit Crisis, Finance

This is the first in a series of posts by guest author, Katherine Duran.

Who can or will ever forget all the investment problems of 2008? Problems that most likely began sometime in 2007 and have yet to take their last curtain call.  Problems that seemed to be independent, yet act in concert to create a perfect storm of financial ruin. Problematic agents, assumptions, and institutions, numerous as they were and continue to be, from the surface seemed mutually exclusive, but underneath were so delicately interdependent that as one failed, they all failed.  It may take years – and many economists – to unravel and deconstruct what has been compared to "The Great Depression".  We've heard the comparison made so much lately that the very idea of the depression that once struck fear into the hearts of many of the older generation is starting to have the opposite effect: we're becoming desensitized to the phrase.  So in this attempt, and many to follow, I will take a closer look at the downfall and collapse of some of the oldest and safest financial institutions this country has ever known.

Today I focus on the highly coveted AAA rating of bonds and securities.

What does the AAA rating mean to you and I?
Top rating awarded to municipal or corporate bonds, as well as securities, by bond rating agencies such as Duff & Phelps/MCM, Fitch Investors Service, Moody's Investors Service, and Standard & Poor's Corp.. Bonds and securities awarded a rating of AAA means that the bonds are of the highest quality, carry the least degree of investment risk, and in the case of bonds are anticipated to pay both interest and principal on time.  Investors looking for safer bets and good advice on where to put their money rely heavily on these ratings not only for guidance and peace of mind, but also a guarantee of ROI.  Now, no one can guarantee ROI, but the idea here is that ROI on a AAA rated investment is extremely likely.
Imagine now that ratings firms, say for example the top three, Standard and Poor's, Moody's and Fitch Investors Service awarded the AAA rating to investments that were less than worth a AAA?  What are the consequences?  What are the criteria for earning a AAA?  Let's just start there.

AAA by any other name…
Each firm has slight differences on the criteria, and even the grade itself, but each firm has generally the same ideas at work here. To illustrate the bond ratings and their meaning, below is Standard & Poor's format:

AAA and AA:  High credit-quality investment grade
AA and BBB:  Medium credit-quality investment grade
BB, B, CCC, CC, C: Low credit-quality (non-investment grade), or "junk bonds" 
D:  Bonds in default for non-payment of principal and/or interest

AAA ratings and the investors that love them.
Investors reaching retirement begin to leave the fast lane of risky investments with higher payoffs for more reliable investments in the form of bonds and securities that make one feel like they reached shelter after the journey of life long planning and preparation.  The trade off for "safe" squirreling of your life savings and earnings is a lower ROI.  But, the money's practically guaranteed to be there, so one has peace of mind.  It's not just those approaching retirement that value AAA investments.Investors that are extremely risk averse, an investor just starting out, investors with not a lot to lose, insurance companies, municipalities, universities or any other organization that has the trust of smaller investors such as a pension fund rely on AAA rated investments.  Consider too banks and insurance brokerages, and many other types of firms whose AAA rated investments to diversify their portfolios.  Now consider less than worthy investments awarded AAA ratings.  According to New York Times (July 9, 2008) as early as 2006, there was trouble brewing in the ratings agencies.  This last July, all three of the above named agencies "expressed a commitment to reforming their ratings practices… Each firm said it welcomed regulatory suggestions from the S.E.C."  further, "Last week [July 2008] , Moody’s acknowledged that some employees had gone astray of internal conduct codes."

The Devil's in the Details.
Today, one doesn't have to look too far to find examples of overrated investments gone bad.  The biggest, and most glaring of these are mortgage backed securities.  How did this come to be, and what could possibly have motivated ratings firms to trade in their solid trust worthy reputation for SEC investigations, possible criminal indictments and loss of investors faith? 

Fees.  Beautiful income fees.  According to Bloomberg.com, as early as 2001 the trouble was well underway with mortgage backed securities when ratings firm "S&P was competing for fees on a $484 million deal called Pinstripe I CDO Ltd."  $484 million doesn't seem like a lot, but "While prospectuses don't disclose fees, Moody's says it charged as much as 11 basis points for structured products, compared with 4.25 basis points for corporate debt. A basis point is a hundredth of a percent. S&P says its fees were comparable. A typical CDO paid 6 to 8 basis points, according to Richard Gugliada, 46, S&P's global ratings chief for CDOs until 2005. That would make rating the Pinstripe deal worth $300,000 or more."  That's just one deal, now multiply that by 10 or more per day.  There's the motivation, even though it's still unsatisfying. The rating firms cultivated their reputation and authority – for decades , in the case of our three firms;  S&P since 1860 (officially as S&P since 1906), Moody's since 1900, and Fitch Investor's Service since 1913.  Analyst "Frank Raiter says his former employer, Standard & Poor's, placed a "For Sale" sign on its reputation on March 20, 2001. That day, a member of an S&P executive committee ordered him, the company's top mortgage official, to grade a real estate investment he'd never reviewed."   It seems that executives, not just analysts were ignoring their firm's conduct rules.

Don't blame the math.
Much has also been written about analysts who used mathematical models rather than relying on "gut instincts" and experience to determine the value of investment offerings.  It is claimed that it was these mathematical models and not good old fashioned hubris that caused the trouble.  These claims are troubling on two levels: first, because it draws attention away from poor executive leadership and the greed that motivated the agencies, and second, ignores the fact that mathematical models are simply algorithms, by design – human design.  Meaning that, given a particular desired outcome, quantitative models can be backwards-constructed so that they produce the desired outcome.  By throwing mathematics under the bus the industry pundits assume that the public will hear "mathematical model" and stop listening; and not hold the ratings agencies accountable.  But most of us have taken introduction to statistics and should know enough to be skeptical of mathematical findings.  At a bare minimum, healthy skepticism is what your stats professor wanted you to come away with!

Consequences in the ratings game.
The SEC only began regulating ratings agencies as early as 2007.  Ratings problems began long before that.  Economists continue to find that foundational cracks in the financial structure may have be
gan somewhere in 2000 or 2001 when nobody was even looking.  Regulators find that they're always a couple of steps behind and a day short.  While ratings agencies are responsible for quite a bit of the mess, they're not alone.  Remember that these firms had no control over who housing loans went to, and inherent to the work of these agencies is a conflict of interest.  Agencies are paid by the companies whose offerings they rate.  That's like politicians paying unbiased newspapers for endorsements.  Instant bias. 

In the future.
While the SEC will continues to study and report their findings, a new age of finance is on the horizon, or at least it should be.  The age of regulation.  With the economy crawling through admitted recession and possibly towards depression, politicians and the public will look to regulation to prevent economic failure like this one in the future. What about the immediate future?  With investigations underway, it's too soon to say what the fallout will be for ratings firms, or more specifically, their executives.

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2 Responses to “AAA Ratings Problem, where’s the trust?”

  1. Katherine, great post!
    The big issue here in my mind is the inherent conflict of interest between the rating agencies and the issuers who are paying their fees to be rated. That has to be completely unwound – and the sooner the better.
    Scott

  2. Deborah says:

    I recently came across your blog and have been reading along. I thought I would leave my first comment. I don’t know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.
    Deborah
    http://termlifeinsurance2.com

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