Why the Ratings Agencies Should Fear Congress

There was a lot of bashing of the ratings agencies this morning at the Portfolio subprime panel. It was timely, coming as it did ahead of Congressional hearings on the ratings agencies and their role in the present mess. Investors and lawmakers seem to be losing faith in the the ratings agencies – but it's the latter which the agencies should fear more, not the former.

The Wall Street Journal says today that "if worries persist, ratings could be viewed as less valuable, and issuers may become less willing to pay firms to rate their bonds". But in reality, so long as the present regulatory regime remains in place, the issuers essentially have no choice but to pay firms to rate their bonds. The universe of bond investors is dominated by large institutional investors who have a mandate to invest only in bonds with a certain rating – and so long as those mandates exist, the ratings agencies will continue to have a license to print money.

What's more, a whole new universe of creditors is going to become very ratings-sensitive in a few months' time, as the long-awaited Basel II capital-adequacy regime gets implemented across the international banking system. The amount of capital that banks are required to hold against any given loan will now be a function of the debtor's credit rating – giving banks every incentive to lend to highly-rated weak companies rather than stronger, lower-rated entities.

Is that possible? Can a highly-rated company really be more likely to default than a credit with a lower credit rating? Yes:

According to Moody’s, corporate bonds rated Baa (their lowest investment grade) had a 5-year average default rate of 2.2% over from the period between 1983 and 2005. However, CDOs with the same Baa ratings suffered 5-year default rates of 24%. Investment grade corporate bonds and investment grade CDOs are not the same, and a CDO with a borderline investment grade rating is really the equivalent to a junk bond.

If you look at Baa-rated municipal bonds, the difference is even larger: the default rate on Baa-rated munis was actually just 0.09%, according to one of the panelists this morning. "There can be a 250x difference in the probability of default for this given Baa rating," he said.

So it's not the investors that the ratings agencies need to worry about: it's the regulators. If they stopped requiring pension funds and the like to invest only in bonds with a certain rating, then demand for ratings would surely plunge.