A Credit Rating Conundrum

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 |  Includes: KBE, MCO, SPGI, SPY, XLF
by: Bear In Mind

While many of us in the investment world already agree that ratings bestowed on bond issuances should be taken with a grain of salt, the Big 3 rating agencies have made an honest and desperate plea.

Immediately following the passage of the Democrats’ historic financial “reform” bill, companies began preparing for what would be a host of new and overreaching regulations which would oversee nearly all financially-related transactions in the United States. Good or bad, everyone agrees that the bill is a massive (2,000+ pages) and highly complex entanglement of rules with the goal of avoiding a catastrophic shock to the economy down the road.

As expected, corporations started crunching numbers and re-writing strategies in order to ensure adherence to the broad spectrum of rules—but a few firms seemed to abandon all hope and confidence in their primary function.

As the Wall Street journal points out (see here), S&P, Moody’s, and Fitch:

…are all refusing to allow their ratings to be used in documentation for new bond sales…

The reason?

The Dodd-Frank financial reform bill is so immense and convoluted that nobody seems to know exactly what many of the rules mean and what unintended consequences will result. Further, the rules are “effective immediately” in relation to new liability placed on the trustworthiness of ratings. In response, these agencies are “refusing to let bond issuers use their ratings” until they flush out exactly what it is they’ll be liable for.

I appreciate this newfound honesty from these agencies. Who could blame them for wanting to ensure they won’t be seized or heavily fined by the government if they make a wrong move? It’s clear that much of the blame for the crisis is bequeathed to these firms, as it was obvious they were bent on churning out favorable ratings in a morally conflicted environment.

But this oddly candid reaction will not only affect investors. It will have impact on everything related, right down to the underlying borrowers (even individual consumers as investment banks package up their debt to sell in secondary markets).

Considering this bill is only a framework that will flush out explicit rules in the coming months, I’d venture to say that any investment related to credit and financials is exposed to potential losses. This includes any asset backed security, from consumer loans to auto debt.

Since S&P (MHP) and Fitch are private, no need to avoid their equity since they have none. (While S&P is actually owned by McGraw-Hill, they have no direct equity issued in secondary markets, and are therefore much less vulnerable to financial regulatory uncertainty as part of a larger conglomerate with other business units.) Moody’s (NYSE:MCO) however is publicly traded, and the provision and freeze in ratings’ use will most definitely have a negative impact on their shares. And obviously, anything with a credit rating should be carefully analyzed using fundamentals of the underlying creditor.

In short, while the agencies ratings aren’t completely useless, they are indeed subject to intense scrutiny and due diligence on the investor’s part.

As for the broad market, I suspect this bill’s unintended impact will be more substantial than any of us had fathomed. Just glancing at the volatility index from the day this bill passed--while some of today’s performance can be attributed to Bernanke’s unease about the economy, it’s safe to assume that much of it is due to the mammoth amount of uncertainty injected into the financial system thanks to the Dodd-Frank Bill. So much for its’ intended goal of “stability”.

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To quote Disneyland’s Thunder Mountain ride: “Hold on to your hats and glasses, this here is [going to be] the wildest ride in the wilderness!”

Disclosure: No positions