Credit rating agencies – are they junk?

John Quiggin has spawned a good discussion about the poor performance of financial credit rating agencies at his website.

This produces some absurd results. For example, Ambac, a mortgage insurer whose shares have lost 92 per cent of their value in the past year, is rated at AA by Fitch. By contrast, Greece, a Eurozone member country, is rated A. Does anyone seriously think the probability of default by Greece is greater than that for Ambac? And Fitch is conservative. Moodys and S&P still have Ambac rated as AAA suggesting, to anyone foolish enough to believe them, that the probability of default is negligible.

In the comments Mugwump offers this interesting insight:-

The solution is to get rid of the effective government-granted monopoly on ratings providers. The ratings used for banks, money markets and state pension funds must be assigned by Nationally Recognized Statistical Rating Organizations, or NRSROs.

In order to achieve the NRSRO designation, and organization must be “nationally recognized as an issuer of credible and reliable ratings by the predominant users of securities ratings.”

So you effectively cannot become an NRSRO unless you’re already an NRSRO. Catch 22.

Check it out.

17 thoughts on “Credit rating agencies – are they junk?

  1. For those who want a reasonably secure guarantee against default, the best advice at present would be to restrict investments to those with an explicit guarantee from a developed-country national or state government

    Has he forgotten South Korea in 1997, Russia in 1998?

    The agencies have made a huge mistake in valuing CDOs of mezzanine mortgage debt. It turns out that if you take the risky piece of hundreds of mortgages and stick them into a pot, the pot is still risky. But to be fair, very few highly paid Wall St analysts saw it either. In fact only the traders at Goldman Sachs spotted their mistake and reportedly made $3bn on the back of it.

    In general, the agencies function very well. The reason is reputation risk. As soon as markets believe an agency is asleep, they will ignore these ratings and the issuers will stop paying exorbitant prices to rate their debt.

    It’s a good system. But all systems have glitches.

  2. “Has he forgotten South Korea in 1997, Russia in 1998?”

    How are these cases relevant? Both were emerging markets, and neither had an external guarantee.

  3. South Korea is an OECD member. They won’t be too happy to be called an emerging market.

    Guarantee from who?

  4. This produces some absurd results. For example, Ambac, a mortgage insurer whose shares have lost 92 per cent of their value in the past year, is rated at AA by Fitch. By contrast, Greece, a Eurozone member country, is rated A. Does anyone seriously think the probability of default by Greece is greater than that for Ambac? And Fitch is conservative. Moodys and S&P still have Ambac rated as AAA suggesting, to anyone foolish enough to believe them, that the probability of default is negligible.

    This stuff is wrong. A sovereign credit rating is different to a private entity rating and from memory there are separate classifications for firms as well in terms of sectors such a life insurance, industrials, banking etc. So looking at a AAA rating for a bank (if there is such a thing) is not the same as looking at a AAA for soverign risk. Quiggin should know this stuff.

    I’m not too sure Mugwump is 100% right there. I recall Fitch suddenly making its presence felt (in the rating business )specializing in the banking sector around the early 90s. I also recall a new rating agency getting set up in the 90s as well but don’t remember its name.

    Yes, the rating guys screwed up and as Pom says so did everyone else. The real story is that people will/should evetually rely more on their own credit assessment rather than outsiders to do it for you.

    On Goldman’s ….. Actually they lost money on mortgages like the rest of the pack. It was the proprietary traders who took the large position on credit default swaps away from the trading and sales desk. I can’t recall where I read this. Prop trades essentially just take bets on markets.

  5. For those who want a reasonably secure guarantee against default, the best advice at present would be to restrict investments to those with an explicit guarantee from a developed-country national or state government

    Well that’s plainly silly as an investment strategy. It’s like throwing the kid out with the bath water. John’s basically telling everyone to say goodbye to the corporate bond market. It isn’t going to happen and nor should it happen. There are plenty of high grade bond issuers that weren’t involved in the mess.

    Would John honeslty want a potentially high grade borrower like BHP to be shut out of the bond market because he thinks only soverign risk is less risky?

    Italy almost lost its rating in the early 90’s as there was concern about default risk. France also lost its AAA at one stage. Even Gemrmany did after unification.

    What’s amusing that at one time high grade corporate bonds were actually thought of as less risky than sovereign debt.

    Oh and I forgot… Britain once had to head to the IMF for a loan in the 60’s as it couldn’t borrow in the Euro markets any longer.

  6. This stuff is wrong. A sovereign credit rating is different to a private entity rating and from memory there are separate classifications for firms as well in terms of sectors such a life insurance, industrials, banking etc. So looking at a AAA rating for a bank (if there is such a thing) is not the same as looking at a AAA for soverign risk. Quiggin should know this stuff.

    JC – Clearly Quiggin does know this stuff because he dealt with it in his article. Specifically:-

    Again from the NYTimes “. Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things.” But lots of organizations are required by charter or legislation, to invest only in AAA, or only in investment-grade securities, and lots of funds advertise to retail customers that they invest only in AAA-rated securities. Fairly clearly, such requirements are inconsistent with the fiduciary obligations they are supposed to enforce.

  7. No he doesn’t.

    He’s trying to convey the idea that a AAA rating for say the US government is the same as a triple rating for Mercedes(if in fact they were AAA)

    Stop changing the topic terje. Want me to repeat what he said?

  8. The way I understood Quiggins article he was not saying that at all. If he was trying to convey that meaning then he failed in my case. My understanding from my reading of his article is that the rating system is different for different classes of debt (eg government versus corporate) but many policies and regulations applying to investment funds etc are often built around an implicit assumption that ratings are equivalent across classes. Please quote what he said if it will help me to understand where you interpret him differently. I don’t want to split hairs but at the moment I’m not understanding your point. Of course it is possible that my interpretation of Quiggins claim is correct but that the claim is wrong.

    And why do you think I was changing the topic? What I said seems entirely relevant. If I’ve got it wrong I’m happy to have it explained.

  9. Here is what Quiggin says:
    <This produces some absurd results. For example, Ambac, a mortgage insurer whose shares have lost 92 per cent of their value in the past year, is rated at AA by Fitch. By contrast, Greece, a Eurozone member country, is rated A. Does anyone seriously think the probability of default by Greece is greater than that for Ambac? And Fitch is conservative. Moodys and S&P still have Ambac rated as AAA suggesting, to anyone foolish enough to believe them, that the probability of default is negligible.

    He’s bascially comparing corporate to sovereign ratings in the above comment. You can’t compare. This is basic stuff.

    Moreover he’s actually suggesting as I said earlier that people ought to move away from corporate debt. This is a truly unique assertion to make even for Quiggin.

  10. JC

    Quiggin is suggesting a move away from corporate debt which is of course bonkers.

    However, from memory, i do believe that the agencies rate in a uniform manner across different classes of debt, whether sovereign, bank or corporate. A rating is simply the probability of you not being paid on time.

  11. Hi Pom:

    I understand them to have a different classification when it’s to do with sovereign debt compared to the rest.

    Then again i always tried to nod off at friday afternoon credit committee meetings. Ever go to one of those meets, pom. It’s how I envisaged hell. I never thought of hell as frightening. I always thought it would a credit meeting on a summer day on Friday in NYC…….. for eternity.

  12. Going from John Quiggin’s comments, it seems that government and corporate risk is assessed differently. JC seems to confirm what JQ said. Though strangely, JC then accuses JQ of not saying it.

    Though if JQ knows of the difference between sovereign and corporate assessments, his introductory paragraph is wrong, and he seems to be contradicting himself.

  13. I don’t agree, JH. Quiggin makes the case that Greece has a lower rating that the monoline. Read it again and see if you get the same impression.

  14. I agree with that JC… and his statement was clearly misleading as the two ratings can’t be compared.

    But in his next paragraph he mentions this himself, saying “Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things”.

    It seems as though JQ is aware of this issue and was using his first paragraph as a bit of rhetorical flourish to spice the interest of the reader. You were right to pick him up on it.

    He goes on to make the relevant point that some investment requirements and advertisements fail to make the distinction, and this is potentially a problem. That’s a fair point.

  15. If government and corporate debt are rated differently then comments #10 and #11 would suggest that they shouldn’t be because in the first instance people like pommy assume they are and in the second instance people like JC are less than certain. People like me don’t matter in this regard because I don’t rely on credit ratings. I put my money in the bank with the best brand and the nicest tellers. Of course if pommy is right (currently he is outvoted by JC and JQ) then there is no problem.

    Of couse it wouldn’t be the first industry to adopt obscure terms filled with pitfalls and contradictions ready to trip up the unwary. It reminds me of the term flamable versus imflamable.

  16. Terje:

    You’ve confused me. As far as I know sovereign debt has different meaning. It has to as it can’t be analyzed in the same way as say GE.

    We’re not talking about ratings that consumer’s use in deciding which banks they use, we’re talking about wholesale type of insto’s figuring out valuations etc. for securities or credit lines between themselves etc.

    Quiggin’s suggestion that people move away from corporate bonds to sovereign supported debt is the biggest problem. Taking his suggestion to it’s abused conclusion would probably cause the collapse of the western world’s financial and most of Main Street as well, as it would mean even prime borrowers like GE are locked of the corporate bond market.

    When it’s all said and done the real fault with this credit mess can be put right back to the governing authorities in the US for causing this mess. They allowed interest rates to remain to low for too long. They pressured the banking system to lend to people that couldn’t afford to repay loans accusing the banking system of racist lending practices thereby planting the seed of destruction by loosening credit standards. Finally the semi government institutions distorted the market such as Freddie Mac etcetera. There was no bloody market failure. This was government failure.

  17. JC,

    My reading of Quiggins article was that he was saying that credit ratings should be applied with consistency. I didn’t read his as saying that the rating agencies should go soft on governments. I agree that his usual ethos is pro-public sector for just about everything but I prefer to deal with the specifics of his article.

    I know that credit ratings matter and I know they are for the wholesale market. However my point was that if they confuse me it is of no real consequence as I don’t use them. However if they confuse the bankers and market makers that I rely on then that is a concern. You and Pommy work in the finance sector so if you two are either wrong or confuse that is a bad sign. If Quiggin or Terje is confused or wrong then that would be a point of note but not such a worry as neither of us are operatives in this sector of the economy. So the question in my mind is “are those that use credit ratings clear about what they mean?”. One would like to hope so. Quiggin seems to suggest that some fund managers and some regulators that rely on credit ratings are confused.

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