Gresham's Law of.... Credit Ratings?

Tuesday's Wall Street Journal lead editorial took on the cozy world of the credit rating agencies on the heels of Monday's reaffirmation of a AAA rating for MBIA and Ambac by S&P and Moody's.


Similarly, on CNBC earlier this week, co-anchor Joe Kernen queried guest host Jack Welch on whether MBIA truly has the financial stability of another AAA credit, GE.


It's worth noting that Jack didn't reply 'from the gut,' to use the title of one of his recent tomes. Instead, he punted and argued for 'getting past this problem' before cleaning up the bond insurers.


The Journal article asks,


"What happens when the feds license only a few companies to provide a service, and then require investors to buy that service?

For the answer, take a look at the mess in today's bond market, where investors have been hanging on whether the main government-appointed credit rating agencies -- Standard and Poor's and Moody's -- would downgrade bond insurers MBIA and Ambac. Equities rallied yesterday when the agencies maintained their AAA ratings.


By now no one should care what the rating agencies think, but the problem is that by law we have to care. Since 1975, the Securities and Exchange Commission has limited competition in the market for credit ratings by anointing only certain firms as "Nationally Recognized Statistical Rating Organizations" (NRSROs). A 2006 law has begun to lead to faster approvals of new entrants, but this follows decades of protection for the incumbent firms."



So there you have it. Our Federal government has done for rating agencies what they did for accountants- required their use, thus creating demand. Only, whereas there are a zillion small accounting firms which practice, there are just a handful of rating agencies.

Still, if you consider the former "Big 8," now down to something like the "Big 3 or 4 (?)," these are the only firms practically large enough to audit large US companies. And their statements no longer mean much on those 10Ks. Auditors long ago stopped avowing that the books they audit are actually correct or non-fraudulent. All they really say now is that their tests didn't find fraud. And, oh yes, they make some statement about following the very loose GAAP principles.

Similarly, rating agencies' ratings are now suspect. Like accountants, they like having customers, so they tend not to be too hard on them- at first. Even now, Ambac is allegedly as strong and as safe in which to invest as is GE.

The Journal goes on to note,

"The SEC went an entire decade, beginning in 1992, without allowing a single new competitor into the market. Thomson reports that in 2007 Moody's rated 95% of corporate bonds, while S&P rated 93%. (Corporate bonds usually carry at least two ratings, so offerings often feature ratings from both S&P and Moody's.) Fitch, at 37%, is the only other firm with significant market share.

Asset-Backed Alert reports a similar story for mortgage-backed and asset-backed issues, which represent pools of auto loans, credit-card receivables and the like. S&P rates 96% of these securities, Moody's 86%, and again Fitch -- also approved by the government -- is the only other significant player, with 58%.

Over time, federal and state laws and regulations have explicitly required NRSRO-rated securities to be held by money market funds, insurers and others. This in turn has created the impression that these ratings are something more than merely financial opinions, which are often less informed than opinions you can read in a newspaper. Every state and federal legislator eager to avoid a repetition of the subprime crisis should begin excising the term NRSRO from statutes and regulations.

With these added strictures about holding assets which have been rated, the agencies truly had a gravy train. By restricting competition by its vetting process, the Federal government has virtually assured an environment of cozy, less-than-meaningful ratings. Without competition to demonstrate who is the more accurate agency, they all rate more or less similarly, collecting fees from the companies who must purchase their ratings, or risk being frozen out of investment by those institutions which require ratings.

In light of the mess now confronting S&P, Moodys and Fitch, the Journal article concludes,

Not surprisingly, the rating agencies are coming up with their own ideas for "reform," none of which seem to include more competition. In its 27-point proposal, S&P suggests more training for its analysts, better review of analytical models, and better disclosure of a security's collateral -- all welcome changes, but remember that Moody's and S&P also suggested reforms after the Enron rating debacle.

S&P also proposes to limit conflicts of interest, by rotating lead analysts and creating a new risk oversight committee, as well as an Office of the Ombudsman. But every business has potential conflicts. In the newspaper industry, we sell ads to the same people we cover. The question is how firms manage these conflicts -- and whether the marketplace is allowed to discipline companies that fail investors."

I think this last point is the crux. There's a conflict of interest whenever a provider of a service is paid by a firm to issue an 'opinion' about that firm. It's simply difficult to believe that, over time, the agencies won't hand out favorable ratings to be sure of continued patronage by a firm.

By now, you'd think there's a sort of Gresham's Law operating in the ratings world. If Ambac and MBIA truly deserve a AAA rating, what does this say about the quality of the other AAA-rated firms issuing debt? Doesn't this debauch the value of every AAA-rated firm's and institution's debt now?