Why Credit Ratings Have Outlived Their Usefulness

Warren Buffett, the world's most renowned and astute investor, testified before Financial Crisis Inquiry Commission last week that the world needs and relies on credit ratings. But he added: "I don't need them myself. I form my own credit judgments."

Today, even as the banking reform bill nears its final form, it seems that financial markets are signaling they don't need credit ratings, either. Consider: Fast-food giant McDonald's (MCD), drugmaker Pfizer (PFE) and retailer Target (TGT) are all rated A by the two premier rating agencies, Moody's (MCO) and Standard & Poor's (MHP). The five-year debt for each of these companies has a yield of between 2.43% and 2.71%. However, financial giants Bank of America (BAC), Citigroup (C) and Goldman Sachs (GS) also carry credit ratings of A. And yet their debt in the capital markets is currently yielding more than double that of the first group -- 4.84% to 4.97%.

Moving Too Slowly, as Usual

What's going on? Clearly, S&P and Moody's seem to believe that the credit risk is about the same for all these corporations, which is why they're all assigned A ratings. Yet, investors perceive financial companies as having double the risk and are demanding higher yields to compensate for it, essentially ignoring the ratings. Sure, Pfizer has had its own share of problems, and Target has seen sales plummet during the last two years of the economic recession. But the big banks are weighed down by uncertainty around the financial regulatory overhaul in Congress now.

"These large banks have so much off-balance-sheet risk that it is extremely difficult to evaluate whether they have the capital to take on the leverage they did," says Patrick Freeland, managing director of Prime Services at Carolina Capital Markets.

Moody's and S&P don't seem to share that view, and while they're watching the bill closely, they haven't lowered the ratings on the large banks yet. Investors say it's another sign of the rating agencies' inability to act quickly enough. It's not happenstance that angry investors who lost gobs of money from faulty investments based on ratings are questioning the validity of credit ratings.

"Flawed" Methodologies

Indeed, as investors found out during the financial crisis, they might buy debt from two companies with the same rating and yet be exposed to two completely different risk profiles. It's an expensive imbalance. To wit: McDonald's debt currently yields 2.43%, while BofA's debt yields 4.97%-- more than double that of the hamburger company's. On a $1 billion loan, that translates to about $25 million more in annual interest payments for BofA.

"These spreads are indicative of the fact that the ratings are wrong and that the markets are further ahead of the curve than the rating agencies," says James Camp, managing director of fixed income at Eagle Asset Management in St. Petersburg, Fla., with $17 billion in assets under management. "While I don't rely on ratings, you can't ignore the fact that the market trades off those ratings, which it shouldn't because the ratings methodologies are proven to be flawed."

A key criticism is that a conflict of interest exists in the rating agencies' business model because they're paid by the issuers of debt. That tarnishes the ratings they issue. "It's a-pay-to-rate scenario -- once you pay for it, it's bound to be biased," says Prime Service's Freeland.

"The Miss Was Huge"

Recent studies of rating agencies have been quite damning -- showing that they assigned top ratings to scads of securities that either defaulted or performed poorly, and such ratings played a large role in the financial crisis. One recent congressional investigation by Senator Carl Levin (D-Mich.) found 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have since been downgraded below investment grade to so-called junk status.

"'The miss was huge," said Phil Angelides, chairman of the Financial Crisis Inquiry Commission at a recent hearing. "Ninety percent downgrade. Even the dumbest kid gets 10% on the exam."

Granted, Moody's and S&P have no control over how the markets behave and what bonds yield. But their clout is unmistakable, especially since government regulators rely on their ratings, and the government had given ratings an endorsement when it instituted a rule in one of its borrowing programs where investors could only buy AAA-rated bonds.

"As the reliance on ratings has spread, their reliability has plummeted. A continuous thread runs through the collapse of Orange County, Enron, Bear Stearns and the issuers of collateralized debt obligations: All received high ratings and then promptly collapsed," say Kathleen Casey, a commissioner with the Securities and Exchange Commission, and Frank Partnoy, a law professor at the University of San Diego. Casey and Partnoy made the case for the government to stop requiring debt issuers to use ratings in a recent op-ed in The New York Times.

Don't Depend on Us

Moody's CEO Ray McDaniel (pictured, right) is well aware of the failures at his firm and the anger those flubs have generated. Testifying on the same day as Warren Buffett before the Financial Crisis Inquiry Commission McDaniel said: "Moody's is certainly not satisfied with the performance of the [mortgage securities] ratings." McDaniel also made the point that ratings are not investment advice. "Our ratings are not, and should not be treated as, statements of fact about past occurrences, guarantees of future performance or investment recommendations."

Indeed, it seems there's widespread agreement not just from astute investors, but from the ratings agencies themselves, on how useful -- or not -- ratings are for making investment decisions. With such unanimous agreement, it's time to look for a less conflict-ridden alternative.