Says Who?

An interesting sub-point in the ongoing Sub-Prime Lending crisis came up the other day: several different groups are blaming the credit rating agencies for giving their blessing to companies whose participation in sub-prime mortgage transactions led directly to the developing crisis. The rating companies are, in turn, saying that they never told anyone that their ratings were a guarantee of success, or failure, or anything else, and that people are free to ignore them. You can read the CNN story about it here until they take it down. Congress is apparently looking into it, with executives from Moody’s and Standard and Poor’s due to be questioned on Wednesday of this week.

Now, it’s certainly true that Moody’s and S & P have a very large influence in the world of commerce; they are the ones who issue the ratings commonly used for bond issues, which has an enormous impact on the world of debt financing. If you’re not familiar with the terms, debt financing refers to any company raising money by borrowing it (as opposed to selling partial interest in the company, usually through shares of stock, which is called equity financing). Some of this involves bank loans, and some of it involves the issue of bonds, which are essentially the company’s IOUs to anyone willing to lend them the money, but in either case, a company’s rating controls the amount they have to pay to get the money (what interest the bank will charge them for a loan or how much interest they have to pay the private investors on the bond issue).

Naturally, the bond market is extremely complicated, with all sorts of different offers and potentials ways to make (and lose) money. In theory, anyone with a financial calculator and a few weeks of business school training (or the equivalent) should be able to determine a corporation’s book value, and based on that and its income, how likely that company is to be able to pay back a loan. The person making the calculations then adds an appropriate amount to the Prime Rate to compensate for how much less likely the company is to repay the loan as opposed to the Federal government. All of these are standard factors, available to anyone who really wants to look them up.

The point is that most people don’t want to look them up, or spend the time calculating the risk factors to determine if a company is taking on too much debt or is too unlikely to ever pay it back. These calculations aren’t beyond the abilities of anyone who ever passed algebra, but they are time consuming and there are thousands of bond offers available at any given moment. So many people turn to the Moody’s or S & P index to get the current ratings of companies they might want to invest in. Here’s what Standard & Poor’s says about their global index, for example. A high ranking on this system tells investors that it’s relatively safe to lend money to the company in question; a low ranking means you are much more likely to lose your money. The very lowest ranks are sometimes called “Junk Bonds” and are often regarded as being nothing more than a more reputable form of buying lottery tickets.

None of this would be much of a scandal by itself, but now several groups are claiming that the rating agencies were paid off to issue higher ratings to sub-prime lenders than those institutions really deserved, and they’re calling on Congress to pass laws requiring the SEC to start overseeing those ratings. It’s doubtful that much can be done about these companies – they all issue the proper legal disclaimers before they make any ratings, and any finance professional knows that these rankings are made by people working for a for-profit research service, not handed down from on high. Even more to the point, a company whose total profits are only $10 million per year has no reasonable chance of paying back $12 million in interest payments each year, and no high-priced rating firm is necessary to figure that out. Congress can’t pass a law requiring people to stop being greedy, gullible, or foolish with their money.

What all of this does mean is that investors are going to have to start paying more attention to the actual financial health of the companies whose bonds they buy, and not just taking the bond ratings as gospel. So the next time somebody tells you that a given company is a “can’t miss” investment, you might want to reply, “Says who?”…