Thursday, September 28, 2006

AAA idea, CCC results

One of the reasons why I started this blog was because there are a lot of issues relating to the bond market that don’t get much attention from the media or other blogs. A good example is credit ratings agencies. The Senate recently passed a bill attempting to encourage more competition among ratings agencies. The idea gets a AAA, but I’m afraid it won’t make much difference.

First a little background. There are basically 3 major ratings agencies for bonds: Moody’s, Standard & Poors, and Fitch. The first two dominate the market. The WSJ reports that they “control” 80% of the market. I’m not sure how they are measuring “control,” because most bonds are rated by multiple agencies. Regardless, suffice to say that Moody’s and S&P are, for all practical purposes, a duopoly in the ratings business.

The complaints I hear about the ratings agencies are two-fold. First, they are notoriously behind the market. Typically a bond has sold off several months in advance of a ratings cut. I posted about this several weeks ago in regards to Ford bonds. In April 2005, when Ford was rated A3 by Moody’s, their bonds were trading 200bps wide to typical BBB-rated names. That was the month that Moody’s first put Ford on negative watch. Just over a year later, the bonds are rated B3. So Ford bonds are trading like they are junk-rated when Moody’s still had them rated A3.

Second is that the ratings agencies are paid by the issuer. So if Disney Corp wants to sell some bonds, it pays S&P and Moody’s to give them a rating. This creates an obvious conflict of interest. On the other hand, who else is going to pay the agencies? They could charge a fee to investors to see their research, but with literally hundreds of thousands of bonds to rate, what would motivate them to rate smaller deals? There are many subscription-based credit research firms, such as Credit Sights, claim to do a better job than the big 2. Maybe so, but generally they only cover larger corporate issuers. They can’t cover the zillions of ABS or municipal deals that S&P and Moody’s do.

I’m not sure what this action by congress is going to do to solve either of these problems. I’ve already said why I think the conflict of interest will be hard to solve. Maybe more competition would make the agencies more responsive, but how to create competition? The reason why Moody’s and S&P dominate the market is because investors trust their ratings more so than any other company. Bond issues rated only by Fitch or some other agency trade at a substantial discount to those rated by Moody’s and S&P. For an issuer, this means that any overt cost savings from going with Fitch as opposed to the big 2 is eliminated in increased interest cost.

Could the market "trust" a third or fourth credit agency? Maybe, but it would take a long period of time for the agency to gain a positive reputation. During that period, the agency would likely lose money, as they would have to convince issuers to pay for their ratings without being to prove that the rating will help lower interest cost. So entering the market would be extremely risky, and I have to wonder whether anyone will be willing to take the risk.

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