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September 29, 2011 at 08:00 PM
Over the past few years, credit rating agencies have done a lot to diminish their credibility. Not only did they contribute to the Great Meltdown by inaccurately rating debt, but they have allowed the role of credit ratings to become murkier. What do the ratings now mean for financial advisors and clients?
AAA in a AA+ Country
Since downgrading the U.S. government’s long-term debt to double-A-plus, Standard & Poor’s has been tripped up by its own scoring system. Four companies retain a higher credit score than the U.S. government: Automatic Data Processing, Exxon Mobil, Johnson & Johnson and Microsoft. Interestingly, this type of thing isn’t supposed to happen, because credit raters employ a “sovereign ceiling” stating that no company can borrow money on better terms than the country where it resides. Yet, triple-A ratings for the four companies mentioned above show the perversity of today’s rating system and how credit raters have broken their own silly rules.
Warren Buffett’s declaration the U.S. deserves a quadruple-A rating may rank as one of the most absurd things said in 2011. Here’s a man who has spent decades evaluating corporate income statements and balance sheets and if any one of these companies he’s evaluated had the U.S. government’s debt burdens or nonsensical methods for dealing with them, it’s a long-shot they would earn a double-A-plus let alone still be in business.
A more accurate view is attributed to Michael Milken, who has been known to point out that sovereign countries have defaulted 30 times as often as private companies, both domestically and foreign. He has stated: “The best credit by far, history has shown, has been the private company.”
Poor Indicators
The most direct indictment of today’s credit rating system is history. Research conducted by the Wall Street Journal analyzing 35 years of data showed credit ratings are ineffective at predicting a government’s risk of defaulting on its debt. Just 12 months before defaulting on their sovereign debt, Russia in 1998 carried a BB-/Ba2 rating. In 2001, Argentina was rated BB/B1 before it defaulted. Each of these grades were six notches above CCC-/Caa3, which is only assigned to debt that’s defaulted with very little possibility of recovery.
Instead of learning from their mistakes, rating agencies perfected them.
In 2007, rating agencies assigned triple-A ratings to approximately 1,300 financial products mostly linked to mortgages. At the time, there were fewer than a dozen U.S. companies with that same pristine rating. Incorrectly assigned ratings facilitated excessive leverage along with slam dunk sales by marketers of garbage debt that would’ve otherwise been impossible to sell. Fitch Ratings, Moody’s and Standard & Poor’s played a key role in triggering the 2007-09 Financial Crisis. Will credit ratings, which remain mostly the same as before, contribute to future meltdowns?
Regulatory Shakeup
The waning confidence in the accuracy of credit ratings is further demonstrated by major shifts in the regulatory landscape.
In April, the SEC voted unanimously to proposed amendments that would remove references to credit ratings in several rules under the Exchange Act. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act federal agencies must review how their existing regulations rely on credit ratings as an assessment of creditworthiness.
