Has the U.S. Lost its Grip on the Credit-Rating Business?

[Editor's Note: Money Morning's Martin Hutchinson, a noted commentator, author and longtime international merchant banker, outlines how the credit-rating-agency business will function in the post-financial-crisis world - and explains what that will mean for investors. His predictions may surprise you.]

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There's a new name in the credit-rating-agency business these days: It's Dagong Global Credit Rating Co. Ltd., and this Beijing-backed business is China's bid for a spot in the global-credit-rating oligopoly.

And Dagong's Chairman Guan Jianzhong doesn't think much of his long-established U.S. competitors.

"The Western rating agencies are politicized and highly ideological and they do not adhere to objective standards," Jianzhong told The Financial Times earlier this month.

Is he right? And does the newly passed Wall Street Reform and Consumer Protection Act correct their flaws, or does it make matters worse? It's a question that affects all investors - even those of us that don't invest in bonds, as we'll soon see.

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Foundations of a Present-Day Mess

The credit-rating-agency system we have today grew up in the 19th Century. It was supposed to provide a way for bond investors to get information about credit quality of the corporate bonds they held or were interested in buying or selling - a bit of data that was very hard to get in those days, given the almost invisible standards of disclosure.

As regulators took over such industries as the insurance sector following the Great Depression, it appeared to make sense to use credit ratings as investment guidelines for the insurance companies' bond portfolios. When securitization came along after 1980, credit-rating agencies were naturally used to provide assurances about the underlying pools of assets that investors had no hope of assessing independently.

With corporate debt, the credit-rating system worked reasonably well.

The rating agencies were paid by the issuer, which was theoretically a conflict of interest. However, investors were protected by the fact that the rating agencies needed to preserve their reputations: If too many AAA-rated companies went belly-up, the rating-agency system would have fallen into disrepute.

Internationally, there were always problems.

Just take Venezuela. For decades, the rating agencies - blinded by the beauty of that country's oil reserves - rated Venezuela as a AAA investment. We saw how badly that ended.

Domestically the system worked pretty well. The rating agencies got pretty good at corporate credit assessment, preserving themselves from trial lawyers by stating firmly that they were only expressing an opinion on the value and quality of securities - like journalists, really.

Securitization: The Credit Rating Wildcard

The problem arose with securitization. It is now clear that neither the originating banks nor the rating agencies really understood securitization credit risk. They took a portfolio of assets being securitized, looked at historical default rates and applied so-called"binominal distribution analysis" to calculate the probability of the bonds defaulting.

If the portfolio consisted only of prime home mortgages, this approach wasn't all that inaccurate.

The problem came with assets of less-than-prime quality, and tranched securitizations, in which the top tranche would be issued as AAA-rated bonds and lower tranches as lower-rated bonds.

According to modern financial theory, the probability of default of the top tranche of even subprime mortgages was very small, indeed. However, the theory failed to take account of the possibility that the defaults might be correlated. If underwriting standards deteriorated, all the mortgages written during a bubble might be of extra-poor quality. If house prices declined nationwide, all the riskier subprime mortgages would be in trouble.

The theory underlying the calculations of default risk was rubbish, so the ratings were rubbish. Yes, rating agencies were in a conflict of interest, and allowed the investment-
bank quants to"help" them in their analysis. But the investment bank quants - who were paid only if deals got done - also did not think hard enough about possible flaws in the theory.

That was the catalyst for the collapse of the U.S. housing market. From late 2007, AAA-rated tranches of subprime mortgages started defaulting. Double securitizations, in which securitized assets were re-securitized (for example, BBB-rated tranches of mortgage bonds were packaged together and tranched again) were even more screwy than ordinary securitizations, because the errors in the calculation were doubled.

Needless to say, rating agencies became pretty discredited. But they haven't been successfully sued, because they were able to claim that their ratings were just like a novel really - artistically elegant, but pure fiction.

The Wrong Solution

The new Wall Street Reform and Consumer Protection Act attacks the rating-agency problem, but misidentifies it. It assumes that the rating agencies were seduced by the issuers into issuing misleading ratings, and that their integrity was at fault.

But that's not really correct: There has been no great epidemic of mis-rated corporate debt defaults. The rating agencies simply did not understand the characteristics of what they were rating in the securitization area - they were stupid rather than venal.

However, the Democrat Congress being what it is, its solution has been to force the rating agencies to take firm legal responsibility for the ratings that they issued - thereby handing them over to the tender mercies of America's trial lawyers when things go wrong.

The New Reality

In the short period since the law passed, the rating agencies have essentially refused to issue public ratings (they'll tell a bond buyer what his bonds should be rated, but only secretly). If this continues, of course, the agencies will soon have no business at all. So it won't continue forever.

In the corporate-credit arena, the market will probably re-establish itself - after some heavy work by the rating agencies' lawyers and a massive increase in costs. After all, the rating agencies really are quite good at rating corporations. However, given modern standards of disclosure, investors are also competent in this area. So the involvement of the rating agencies won't be absolutely essential.

A problem remains with securitizations. For anything but the most standard assets, investors have no way of accurately assessing the credit risk of a pool of miscellaneous assets. Given the legal liability they now face, the rating agencies will be extremely cautious in granting ratings to anything that isn't rock-solid.

There are two possibilities. The legal advisors may tell the rating agencies that the risks of rating securitizations is simply too great - in which case securitization will disappear altogether, and banks will be forced to hold the home mortgages, credit-card debts and auto loans they originate. That might work in the long run, but would cause huge disruption for several years, and probably a very deep recession.

The most likely outcome will be for the rating agencies to continue to rate securitizations, but very cautiously. In that case, mortgages, auto loans and credit cards will be more difficult to get, but not impossible, and the junk issued during the bubble of 2002-07 will not reappear. On balance - given the tendency of the U.S. consumer to take on too much debt - this could be a very good thing.

For investors who buy bonds, credit ratings in 2011 may be somewhat more conservative than they have been. So a 2011 ‘AA' may be equivalent to a 2010 ‘AAA.' For investors who as consumers want a mortgage, credit cards or an auto loan, the future does not appear so bright.

Of course, we could always get our credit ratings from Dagong - which, incidentally, is backed by Beijing. If that's the route we travel, allow me to wish the U.S. trial lawyer community the best of luck going forward. When the time does come to sue, they'll not find it so simple to navigate China's legal system....

[Editor's Note: Money Morning's Martin Hutchinson has been on a global hot streak.

Here's what we mean. Just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns - and one is up nearly 25%. He again recommended Korea - which analysts were downgrading - only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.

A longtime international merchant banker, Hutchinson has a nose for profits instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll the time well spent.]

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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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