The lawsuit between the city of Phoenix (plaintiff) and Ambac Financial Group (ABK) (defendant) brings us back to a crucial problem that financial reform has yet to address: the lack of ratings consistency.
Problem One: A Moody’s (MCO) rating is not equivalent to an S&P rating. The former is an expected loss rating – the latter is a default probability rating. They are also mapped to different scales. A Moody’s rating of Aa2 is thus not comparable to that of a AA from S&P. In a world where certain funds and companies are restricted to purchasing investment-grade securities, for example, isn’t it convenient that both agencies can provide their own definitions of “investment grades?” (Relative to their respective scales, investment-grade securities are those rated Baa3 or higher by Moody’s and BBB- or higher by S&P.)
If an investment-grade rating is required for the transaction to close, what stops a rating agency from either designing the scale to achieve the investment-grade rating, or even adding an artificial qualitative factor to its analysis to allow the bond to achieve the investment-grade status? Certainly, absent any legal liability or reputational risk to the rating agencies’ government-mandated oligopoly, one has to wonder what incentives the rating agencies have to be accurate.
In his congressional testimony on the role of the credit rating agencies, Arturo Cifuentes (2008) summarized this predicament as follows:
This situation is conceptually untenable. Who, in his right mind, would enact a law stating—for example—that in Washington, D.C. you cannot build a ‘tall building,’ and then, give a private company the right to specify what ‘tall building’ means? A five-story building? A ten-story building? Who knows?
I’m not conjecturing that this happens or doesn’t happen; rather I’m commenting on the misalignment of incentives that serves to jeopardize investor confidence in the integrity of the ratings process.
Problem Two: A Moody’s rating of Aa2 on a municipal bond is not equivalent even to a Moody’s rating of Aa2 on a corporate bond. Why are these scales different? (Notably, the structured finance ratings are purportedly mapped to idealized corporate ratings scales.)
As I understand it from Bloomberg reporter Christine Richard’s coverage of Phoenix v. Ambac, Phoenix is suing Ambac for having to pay “grossly excessive bond insurance premiums” under a system for rating municipal debt that favors corporate borrowers. According to the complaint (.pdf),
[m]unicipalities have been forced to pay enormous amounts in bond insurance premiums simply so that they can enjoy the same credit rating on their bonds as private sector bond issuers with equivalent or greater default risks.
This begs the question: why does a dual rating system exist, and why does it arbitrarily favor corporations over municipalities?
Looking a little deeper, we should ask why it was made more onerous for municipalities to reach the AAA rating threshold? If more (or most) of the municipalities would have deserved to be rated AAA based on their pure default risk fundamentals, surely the insurance monolines would have had substantially less business wrapping debt to the coveted AAA level. Was their insurance thus largely superfluous? Put another way, why was it easier for corporations to have their debt rated AAA than for municipalities, despite the comparatively lower historical muni default rate?
It seems odd that Moody’s has waited until Tuesday to adopt the same ratings scale for munis and corporates; it seems to conflict with our government’s intent (and our taxpayers’ pockets) to place an additional strain on our municipalities’ ability to raise capital; and it seems to cloud investors’ understanding to have two distinct ratings scales with identical symbols.
A single scale brings with it the numerous advantages of allowing apples-to-apples ratings comparison. And it promotes a key reform measure: enabling investor due diligence and encouraging a return to an investment culture that promotes risk-responsibility and value-creation.
We desperately need to move away from an environment in which investors outsource their analyses to rating agencies or broker-dealers, in search of the highest yielding asset at each rating level. Real credit and non-credit risks exist. We ought to encourage caveat emptor, and provide the tools, transparency, and consistency necessary for investors to perform the required investigation into securities and their ratings, both pre- and post-investment.
Shall our ratings scales, too, be made of sterner stuff?
Disclosure: No positions