From the August 2012 issue of Research Magazine • Subscribe!

What Do Credit Ratings Tell Us?

Moody’s Investors Service gave its token credit downgrade to a dozen global banks (IXG) including five of the six largest U.S. banks—and financial stocks responded by shooting higher. What’s going on?

Just after the downgrades were announced, the SPDR S&P Bank ETF (KBE) closed ahead by 1.36% while financial stocks (XLK) within the S&P 500 ended higher by 0.92%. Have ratings become a contrarian indicator? Why would the financial sector rally in the face of declining credit quality?

One explanation is the waning credibility of credit rating agencies.

It’s no secret that mis-rated debt contributed in part to the 2008-09 financial crisis.

A Senate panel found that rating agencies directly participated in a “race to the bottom” by inflating creditworthiness to win business from Wall Street banks.

Since the crisis, the credit rating trio—Fitch Ratings, Moody’s, and Standard & Poor’s—have struggled to wipe clean their marred reputations. Yet, cosmetic changes and phony reforms have hardly increased the accuracy of ratings, nor have they altered the way ratings are doled out.

Concerning Morgan Stanley’s June downgrade, the Wall Street Journal reported that Morgan Stanley’s CEO James Gorman “can pat himself on the back after four months of back and forth and public lobbying” to convince Moody’s not to downgrade the bank by too much. Did it work? Moody’s reduced the Morgan Stanley’s credit rating by just two notches versus a much worse expected cut of three notches.

The Select Sector Financial SPDR (XLF), which includes Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM), and Morgan Stanley (MS) is ahead 10.6% as of late June.

The credit market moves faster than rating agencies—and unlike ratings, its opinions are fairly straightforward. And when downgrades aren’t as bad as what the market expects, guess what? A rally can occur.

Likewise, when ratings are worse than expected, a rally can still occur. (See the 2011-12 rally in U.S. Treasuries, despite S&P’s credit downgrade of the U.S. government.)

Here’s the bottom line: The credit market already doesn’t wait for credit ratings to confirm what it already knows. Shouldn’t investors be doing the same?

 

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