December 2018 | Retail Version

When it comes to investing in fixed income securities, many investors have traditionally relied on the evaluations of Credit Ratings Agencies (CRAs), and especially those of the “Big Three” (Moody’s Investors Service, Standard & Poor’s, and Fitch’s Ratings, Ltd.) in helping them in decision-making relating to the purchase of corporate and government bonds and structured finance debt. These agencies provide evaluative services culminating in the publication of ratings of the creditworthiness of debt securities and their issuers, with investors using the information (credit rating) to determine the risk associated with their investments. A higher credit rating implies lower risk and a higher likelihood that the debt will be repaid.

On the heels of the financial crisis of 2007-2008 and the associated subprime
mortgage meltdown, there has been much scrutiny of the CRAs and concerns over the accuracy of their credit ratings and information that they supply to investors. Following the financial crisis, the CRAs were accused of giving higher ratings to sub-prime mortgages and misrepresenting the risks associated with them.

The big question now is whether the ratings business has changed much since the financial crisis. We believe that the simple answer is not really. Congressional oversight and accountability measures have proven to be
ineffective.

One of the main problems is the way CRA revenues are derived and the business model behind it all. CRAs mainly generate revenues from issuers of debt who are seeking a credit rating. They also generate additional earnings from subscribers who receive published ratings and related credit reports. Corporate and government bonds must have a credit rating to be issued. However, here is the rub. If an issuer receives a rating from a CRA and doesn’t like the rating they receive, then they can shop around for a better one.

Since CRAs are competing with one another for business, their business model can conflict with the interest of investors. More specifically, it means that credit ratings agencies no longer have incentives that are closely aligned with those of their customers. In other words, CRAs have an incentive to offer lenient ratings in order to get business from large customers who issue debt
(Levich, Majnoni, & Reinhart, 2012). Even though credit ratings agencies ratings have been proven time and time again to be inaccurate (e.g., in their assessment of subprime mortgage securities in 2007-2008), there is a continued demand for their services because institutional investors need summary statistics on the creditworthiness of their debt holdings.

According to a report by Gary Burtless, Senior Fellow-Economic Studies at the Brookings Institute, “Some investors must use a flawed and discredited product because no other alternative is readily available…Their ratings may be flawed, but for a wide range of investors the agencies’ ratings are better than no ratings at all.” There is therefore the need to identify alternative sources of information that investment professionals can use to evaluate credit quality and risk.