Credit rating agencies draw criticism

NEW YORK - For the big three credit rating agencies, growing criticism this past week that their ratings systems are flawed must have sounded like a familiar refrain.

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are being criticized by government officials and some investor groups for not identifying weakness in subprime mortgage-backed securities before they went sour and contributed to massive loss in financial firms and, in turn, the stock market. They’re also criticized for having too cozy a relationship with the debt issuers that pay them for their ratings.

This isn’t the first time the rating agencies have found themselves under pressure. The beleaguered industry got similar complaints after the collapse of Enron Corp. in 2001, and before that the bankruptcy of Orange County, Calif., in 1994.

In all three situations, ratings assigned to these issuers went from near-stellar to junk almost overnight. As the agencies begin to think about changing the way they do business, analysts say investors must become more vigilant about what debt securities they sink money into — and not rely solely on what the rating agencies say.

“This happens every other year or so when something shakes up the ratings industry and ends up on the Op-Ed pages,” said Martin Fridson, the former head of Merrill Lynch high-yield research and now proprietor of the specialist firm FridsonVision. “You have to do extra homework, you have to be wary about the way securities are being marketed, and use the ratings that are out there as just a tool.”

Investors are plowing more money than ever into fixed-income products, from municipal bonds to exchange traded funds. According to the Securities Industry and Financial Markets Association, a New Yorkbased trade group, outstanding public and private debt underwritten by bonds was valued at about $25 trillion.

Some 10 percent of corporate bonds are held directly by individual investors, while institutions such as pension funds hold the rest, according to the group. These securities — more conservative than stocks — are an integral part of retirement planning and diversifying portfolios during rocky times for equities.

Fridson and others say most investors don’t hold the kind of opaque asset-backed securities that caused global banks to lose about $130 billion since last year. But there are certain tip-offs investors should watch for when investing in the fixed-income markets — no matter what ratings the securities hold.

For instance, he said “one sure guide is to be skeptical if you see something yielding much more than comparably rated bonds.” Investors might also obtain fixed-income holdings through investment managers — such as Vanguard or PIMCO — where analysts scrutinize debt issues beyond just the ratings.

“Over the last six months, a lot of people have learned the hard way that this risk exists — and that the rating agencies aren’t fool proof,” said John Flahive, director of fixed income at BNY Mellon Wealth Management. “We’ve been reminding clients for a long while of the risk, which is why you hire a professional manager that you can use as a safeguard.”

Rating agencies, which are regulated by the Securities and Exchange Commission, have been pressured to sell subscriptions to investors for their ratings instead of taking payment right from debt issuers; that, many observers believe, will avoid potential conflicts of interest. Debt issuers seek out higher ratings because that makes it easier to raise money in the capital markets.

And, aside from that, the agencies have already taken some preliminary steps to deflect such criticism and ease mounting regulatory and government concerns.

This past week, S&P said it is aiming to improve governance, from establishing an ombudsman’s office to address complaints to hiring an external firm for better oversight. Moody’s also said it was considering changes in how it rates mortgage-related securities. But, that has left many on Wall Street asking if this will be enough — and wonder if the industry itself will begin to shift to other rating models.