Can We Trust the Bond Raters?

Most investors have neither the time nor the expertise to do their own credit appraisal for potential bond investments. But assessing default risk requires a creditworthiness evaluation. Enter credit rating agencies—a way to receive a third-party credit appraisal. But at least two of these, Standard & Poor’s and Moody’s, reportedly had “investment grade” ratings on Enron just a few weeks before its financial meltdown.1 Similar oversights occurred on WorldCom and Italian corporate giant Parmalat. Four of these raters have achieved the status of “Nationally Recognized Statistical Rating Organizations” (NRSRO) – so designated by the SEC, which started this process in 1975. These four—Standard & Poor’s, Moody’s Investors Services, Fitch Ratings, and Dominion Bond Rating Service—command significant market power, and have recently come under fire for questionable ethics two areas: (1) conflict of interest, and (2) timeliness of rating changes. Most bond ratings are paid for by the bond issuer as a way to broaden the market appeal of its bonds. Companies want to be rated because the market for publicly traded unrated issues is much smaller and is illiquid (many institutional investors have policies limiting investments to rated bonds). The lower a bond is rated, the higher the perceived default risk, and the higher the interest rate required by bond investors. Conflict of interest may arise because it is not in the best interest of the rater to downgrade the bonds of the corporate customer paying for the rating. There may be an upward bias to ratings, and raters may be reluctant to downgrade issues even if the issuer’s ability to pay interest and repay principal is declining. The Senate Governmental Affairs Committee found that raters should have asked more and better questions in the raters’ private discussions with companies such as Enron and Xerox. The Sarbanes Oxley law enacted in 2002 dictated that the SEC conduct a review of credit rating agencies. The SEC asked for comments from the corporate community, leading the Association for Financial Professionals to conduct a survey of its membership of treasury and finance professionals. The survey responses were clear: (1) even though the raters say they serve the interests of debt investors first and foremost, only 22% of respondents believe that investors’ interests are favored; (2) more than 70% of these professionals agreed that the SEC should review the NRSROs periodically; and (as respondents whose companies have rated debt) (3) only 40% believe that changes in their companies’ ratings are made on a timely basis.2 One rating agency responded to these charges by asserting that the ratings process is fair and that it must balance investor and corporate issuer interests. Investors want faster rating changes, but corporate issuers want slower and more deliberate adjustments to ratings. The fact remains that it is the investors’ interests that should be kept primary in the ratings process, however. Doing risk-return analysis in the bond markets depends on trustworthy, accurate, timely information. No doubt the increased scrutiny from the SEC, regardless of any registration process that might or might not be added in the future, will add to the value of the ratings received by the investing public.

1 Lisa Yoon, “Downgrade Possible? SEC Looking at Credit Raters”. http://www.cfo.com (June 9, 2003). Accessed 6/13/2004. 2 Association for Financial Professionals, “Rating Agencies Survey: Accuracy, Timeliness, and Regulation.” November 2002. http://www.afponline.org/pub/pdf/ratings_survey.pdf. Accessed 6/14/2004.