Why do S&P, Moody’s and Fitch matter? [Chicago Tribune]

Jan. 08--"U.S. loses AAA credit rating as S&P slams debt levels, political process" -- Bloomberg.com, Aug. 6

"Moody's downgrades Sears further into junk" -- Wall Street Journal MarketWatch, Jan. 4

"Fitch dings U.S. credit outlook" -- CNN Money, Nov. 28

It's enough to make a stock market skip a beat and raises the question of how the three leading credit-rating agencies -- Standard & Poor's Corp., Moody's Investors Service and Fitch Ratings -- have become the be-all and end-all of creditworthiness.

"(Credit rating agencies) serve the purpose of assisting investors in evaluating the safety and soundness of a particular security," said John Soffronoff, president of New York-based full-service risk advisory firm ICS Risk Advisors and a former review examiner at the Federal Deposit Insurance Corp. "Rather than each investor individually having to do due diligence (to rate the creditworthiness), they can rely on the agencies' ratings."

The three agencies, authorized by the Securities and Exchange Commission, basically rate companies by assessing the soundness of their business plan, the strength of their balance sheets, their projected income and cash flows and the quality of their assets and management, said Mark Newlin, managing director at Mesirow Financial in Chicago. Because of this, their ratings tend to be similar. Newlin added that if ratings differ among the agencies, it's often an issue of how recently each has reviewed the company or government.

But there are a few differences. On a scale of AAA to C, highest to lowest, Moody's assesses investor loss in the event of a default. S&P and Fitch measure the likelihood that a security will default, in ratings from AAA to D. The higher the rating, the lower the risk for investors.

In addition, "Fitch carved out a niche in structured bonds and asset- and mortgage-backed securities," Newlin said.

"Credit agencies typically have very open lines of communication with the (bond) issuer, more so than even some institutional investors can develop," he said. "They can even, in some cases, get nonpublic information, so presumably they have more information than the typical investor. For that reason, it's not wise to ignore these ratings, even if you have your own internal staff."

Still, they do get it wrong. Take Enron Corp. S&P, Moody's and Fitch gave no indication of the energy company's financial trouble until just days before Enron filed for bankruptcy in 2001. And the three have been under scrutiny for giving high, "investment-quality" ratings to unworthy mortgage-backed securities, which triggered the most recent economic downturn.

"(The credit agencies have) gotten a lot of criticism over missing the housing bubble, which has led a lot of people to question their credibility," Newlin said. "But ... no one that I know of, either in the agencies, at Mesirow or in the big brokerage firms that were packaging securities, had 30 percent declines built into their pricing or risk models."

So why do their ratings matter?

"They're government-sanctioned rating agencies, so they're very powerful," said Joseph Harowski, a certified financial planner with Chicago-based Smart Choice Financial Planning. "(Companies and governments) have to offer a higher interest rate just to get anyone to nibble (at their debt) because of their lowered (credit) rating. (The still-high rating) is why the U.S. interest rates are so low to help finance the debt, which has tripled in the last four years."

A lack of competition also dogs the three leading agencies in a true chicken-and-egg situation. To be considered for the SEC designation, a credit agency must be deemed a "nationally recognized statistical ratings organization." But most pension funds and investors can't touch a bond that's not rated by an SEC-designated agency: S&P, Moody's or Fitch.

"(Today's rating business is) pretty darn close to an oligopoly," Soffronoff said. "When you look at the importance that credit rating agencies have and the notoriety they need to become one, it would be very difficult to enter that market without that well-known name."

And agencies are paid by the bond issuers they rate.

"The agencies are supposed to be independent, but they're paid by the companies they rate," Soffronoff said. "And that company will benefit from having a better rating, so there's an inherent conflict there."

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