Bond Rating -- One Sweet Racket

Last week, a friend, outraged by S&P’s downgrade of US debt, demanded “who are these guys -- 5 guys sitting around a table somewhere?” I set out to answer his question. Here's what I've learned about how “these guys” make their judgments and their money, and whether I am comfortable with their ratings of US debt.

Who are these guys?
S& P is one of ten NRSROs, Nationally Recognized Statistical Rating Organizations, credit rating agencies which the SEC permits financial firms to use to qualify their net capital reserve requirements, i.e., the amount of readily available cash they have to keep on hand to pay depositors withdrawals. The question is how safe and how liquid the reserves are. Degree of safety is reflected in their credit ratings, as determined by a rating agency that, in turn, must be accredited by the SEC.

As you know, the three majors are S&P, Moody’s and Fitch.
Standard and Poors has been a division of McGraw Hill since 1966. Roughly 5,000 people in offices in 23 countries. They racked up sales last year of $1,695 million, and operating profits were $762 million, or 45%! They make up 27% of McG-H’s sales but 48% of its profits. Their roots go back 150 years to Poor’s review of railroad and canal companies, published in 1860.

Fitch is the smallest of the three. It is a subsidiary of a London rating agency which in turn is owned by a French holding company, so data on Fitch are harder to come by. Though smaller, Fitch frequently positions itself as the "tie-breaker" when the other two agencies have dissimilar ratings.

S&P gets the headlines (and is getting even more for their role in the financial crises of 2008), but the biggest of the three is Moody’s. And it is the only independent; Moody’s Corp. is traded on the NYSE. They generated $2.032 billion in revenues last year and produced an operating margin of 41%. John Moody, 1909, invented the rating scale Aaa to C, and now all three use a variation of that scale. Last year Moody’s Rated debts of 12,000 corporations, 25,000 public issuers, and 106,000 structured financial obligations.

This is a profitable business. S&P: 45% operating profit; Moody’s: 41%. By comparison, Boeing’s operating profit margin was 22% last year. And these agencies have relatively little capital invested – office leases and computers -- compared to the capital assets Boeing needs to generate that 22%. Little wonder that Warren Buffet owns 12% of Moody’s and Hedge funds own another 36%.

Where does the money come from and what do they do to earn it?
The bulk of their revenues come from the issuers of the bonds being rated. (But the US Treasury does not pay for ratings.) In the case of corporations and municipalities, this raises conflict of interest potential since the bond issuer has an incentive to hire the agency most likely to give it a good rating. The agencies argue that in this age of easy sharing data via emails and texting, a subscription-based model would not be profitable. Further, a rating agency often learns non-public information and, under an SEC rule, such information may only be used if ratings are made available to the public for free. So issuers pay, like it or not.

What do the ratings mean? What is the difference between a Triple A and a Double AA?
AAA: Obligations judged to be of the highest quality, with minimal credit risk.
AA: Obligations judged to be of high quality and subject to very low credit risk. And so on down the line.
Then, to further slice the cake, Moody’s adds numerical modifiers 1, 2, and 3 to each rating classification. AA 1 indicates that the obligation ranks in the higher end of its group of AAs; a 2 indicates a mid-range ranking; and a 3 indicates a ranking in the lower end of the AAs. S&P uses a plus, as in AA+; a neutral, AA; and a minus, AA-, rather than numbers.
In all, there are 21 rating categories, with angel-on-head-of-pin distinctions between them.

Note how indefinite are the words: indicates, very low, higher end, minimal, highest – all quotes from Moody’s materials.

How do they determine a rating?
They have armies of analysts, industry and country experts who basically follow a three step process. Here's Moody’s description of how they rate sovereign debt:
“Step 1: Country economic resiliency
The first step consists in determining the shock-absorption capacity of the country, based on the combination of two key factors:
Factor 1: the country’s economic strength, in particular the GDP per capita -- the single best indicator of economic robustness ....
Factor 2: the institutional strength of the country, the key question being whether or not the quality of a country’s framework and governance – such as respect of property rights, transparency, the efficiency and predictability of government action, the degree of consensus on the key goals of political action – is conducive to respect for contractual obligations.
“Combining these two indicators helps determine the degree of resiliency, and positions the country in the rating scale: very high, high, moderate, low or very low.
“Step 2: Government financial robustness The second step focuses directly on debt itself, a combination of
Factor 3: the financial strength of the government. The question is to determine what must be repaid ... and the ability of the government to mobilize resources: raise taxes, cut spending, sell assets, ...
And factor 4: the susceptibility to adverse economic, financial or political events....
“Step 3: Determining the rating
The third stage consists in adjusting the degree of resiliency to the degree of financial robustness. This results in the identification of a rating range.
“The determination of the exact rating is done on the basis of a peer comparison, in other words, relative to whom, and weighting additional factors that may not have been adequately captured earlier.”
(Does this not begin to sound rather fuzzy?)
The findings and recommendations then go to a rating committee. In Fitch’s case, it is 13 senior executives chaired by Stephen Joynt, Chief Executive Officer. So, not five guys sitting around the table, but 13.

Well, what do I conclude?
About ratings: They are imprecise judgments. In the words of Stephen Joynt CEO of Fitch,”Simply put, ratings are a credit opinion.”
And note that ratings are relative, not absolute. While they don’t say it in so many words, their “peer review” logic leads to this conclusion: if all nations were shaky and at risk, the least shaky bond of the bunch, no matter how risky, would still be rated AAA.

About their ratings of US debt: As you know, Fitch and Moody’s have reaffirmed their AAA rating on US Debt, S&P has downgraded to AA+. I’d bore the hell out of you, if I haven’t already, to go into all the detail of their judgments. Just let me say that if you’re a long-range optimist, Fitch and Moody are right. But if you’re a pessimist about the medium term, S&P also is right. And I agree, both mid-term and long-term. In the mid-term, until January of 2013, we will have a Washington mess on our hands and that does increase the risk of a stupid – read tea party highjacking of the GOP – default because of Congress’ inability to reach a balanced compromise.

About the rating industry: If you intend to issue debt and want to have insurance companies, pension funds, and banks buy your notes and bonds, you have to use, i.e., to pay, a rating service; the few services available to you are a government-sanctioned and protected oligopoly; like all oligopolies, they have pricing power to set rates without having to break any laws about price-fixing.
So, they make huge profits on minimal investment.
In other words, the rating agency business is one sweet racket.