Ratings Agencies Are Always the Last to Know

In recent weeks leading up to Greece's orderly default, all three of the major ratings agencies had downgraded Greece to their lowest ratings above default. Fitch got the ball rolling on Feb. 22 by assigning it a rating of C, below only CCC on its ratings scale. (It's since raised that rating to B-.) One week later, Standard & Poor's -- a unit of McGraw-Hill (NYS: MHP) -- cut the country's long-term credit rating to "selective default." Finally, Moody's (NYS: MCO) downgraded Greece's sovereign debt rating to C, the lowest rung on its ratings scale.

To the astute investor, the value of these downgrades is eerily reminiscent of the agencies' collective performance on the eve of the financial crisis. Moody's put Lehman Brothers' investment-grade A2 rating "on review" a mere five days before it filed for bankruptcy. Standard & Poor's gave American International Group (NYS: AIG) an investment-grade A rating less than a week before the insurance company was nationalized. Merrill Lynch and Bear Stearns sported investment-grade ratings when they were rescued by Bank of America (NYS: BAC) and JPMorgan Chase (NYS: JPM) , respectively. And both Fannie Mae and Freddie Mac had highly coveted AAA ratings at the time they were forced into conservatorship.

More recently, all three of the ratings agencies effectively missed the impending collapse of derivatives broker MF Global, which we covered extensively in our award-winning series, "The Astonishing Collapse of MF Global." Moody's and Fitch didn't remove the company's investment-grade rating until a measly six days before it filed for bankruptcy protection. And Standard & Poor's waited until the day of MF Global's filing to downgrade the then-defunct broker.

An important lesson for investors
While it's hard to argue with the downgrades mentioned above, their belated nature should serve as an important lesson to investors: You should never rely on ratings agencies for information -- be it timely or not -- about the health or quality of an investment. Indeed, even if you were to pretend that the agencies' decisions are not tainted by conflicts of interest -- which they are -- their value is nevertheless negated by the passage of time.

The performance of the ratings agencies in the Enron debacle illustrates this point. Although the failing energy company had been faking a large portion of its profits for years by the time it declared bankruptcy in December 2001, the rating agencies didn't downgrade its debt to junk status until only four days before its collapse. Investors in Enron's stock and bonds accordingly lost millions.

One reason they missed the boat was that the ratings agencies' analysts simply weren't paying attention. In hearings on the matter before Congress, for instance, an S&P analyst who covered Enron confessed that he hadn't even read some of the company's financial filings. Analysts are human, let's not forget, and humans have a biological tendency to be both lazy and prone to error.

A second, more pernicious reason, however, was that Enron had exerted pressure on the ratings agencies behind the scenes. When it learned that Moody's was about to downgrade its bonds to junk status in November 2001, the agency's executives received calls from the CEOs of Chevron, JPMorgan, and the New York Stock Exchange, among others. Former Treasury secretary Robert Rubin even jumped in on the action by reaching out to officials in the executive branch. Not surprisingly, in turn, Moody's both delayed and decreased the extent of its downgrade, allowing Enron's bonds to retain their investment-grade rating -- albeit a lower one than before.

A final reason of more recent vintage is that ratings agencies often don't have the manpower or expertise to accurately rate companies or debt instruments even if they wanted to. In 2009 Alan Greenspan noted that some of the rated debt instruments responsible for the financial crisis were so complicated that even the Federal Reserve couldn't figure them out -- and it employs hundreds of the nation's top economists.

In short, you don't want to depend on ratings agencies for your understanding of the health or quality of an investment. They're the last to know.

At the time thisarticle was published Fool contributor John Maxfield owns shares in Bank of America.The Motley Fool owns shares of JPMorgan Chase and Bank of America.Motley Fool newsletter serviceshave recommended buying shares of Moody's. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.