Who Watches The Watchers?

Are ratings agencies fatally conflicted?

During the financial crisis the credit-rating agencies came under heavy fire for giving AAA ratings to subprime conduits that later experienced losses. Calpers and other investors filed lawsuits, alleging that the agencies knew, or should have known, that the bonds they rated were junk.

The ratings agencies are supposed to tell investors how creditworthy a borrower is. The three largest agencies—Moody’s, S&P, and Fitch—control 90% of the market. They operate under an issuer-pays approach: the issuer engages one or more agencies; the agency conducts its due diligence and publishes a rating; and investors use this rating to help them evaluate the bonds. Ratings are publically available, free of charge, to all investors. The ratings provide a standardized reference point for portfolio managers.

There’s a conflict: borrowers pay the agencies to have the agencies tell the world what they think of the borrower. But the alternatives—user pays, or public funding—have their own problems: agency costs, or lack of visibility. Unless you subscribe to Morningstar, you don’t know their ratings. They don’t put out press releases. And internal ratings, which professional money-managers like Charter use, aren’t much good for public policy purposes..

The ratings agencies are the guardians of the credit market. But who will guard the guardians?

Douglas R. Tengdin, CFA

Chief Investment Officer

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