Are Credit Ratings Losing their Influence?


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For credit rating agencies, who typically move at a snail's pace, it's been an unusually busy week.

Moody's Investors Services ( MCO ) announced that it might downgrade the U.S. government's credit rating and it gave Greece a 50 percent chance of defaulting on its debt. Moody's also said large U.S. banks could be at risk for credit downgrades because financial help from the government was no longer a safe assumption. What a week!

Still, none of these major announcements solidified the investing public's opinion that credit ratings are any more accurate or believable.

Some Progress but Not Much
Recognizing these monster shortcomings, the Securities and Exchange Commission (SEC) recently proposed new rules for credit raters, who have done an excellent job of skirting most securities rules governing their behavior. 

'In passing the Dodd-Frank Act, Congress noted that credit ratings applied to structured financial products proved inaccurate and contributed significantly to the mismanagement of risks by financial institutions and investors,' said SEC Chairman Mary L. Schapiro. 'Our proposed rules are intended to strengthen the integrity and improve the transparency of credit ratings.' No one knows if the SEC's proposals will be effective remedies, but a Hail Mary try certainly can't hurt.

It seems credit ratings are still timidly assigned for the purpose of not offending the institution being graded versus giving investors meaningful insight as to the true financial condition of the entity. This assumes, probably incorrectly, that credit raters even know the true financial condition of whomever or whatever they're rating.

Collecting Victories
In May, the three major U.S. credit rating agencies won the dismissal of lawsuits that aimed to hold them liable for acting as 'underwriters' by helping banks to dress up otherwise worthless debt securities with pristine ratings. Likewise, credit raters have been rightfully blamed for contributing to the 2008-09 financial crisis by issuing inaccurate ratings on high risk securities. The agencies' counter argument is that their credit opinions are protected by the First Amendment.

The 2nd Circuit Court agreed with credit agencies saying they did not help distribute the securities but merely aided others to do so with their ratings. 'Merely commenting on draft offering documents does not constitute the requisite participation in underwriting,' stated Circuit Judge Reena Raggi, writing for a three-judge panel.

Put another way, rosy credit opinions are not against the law and neither is collaborating with securities firms to help them sell questionable debt.

Credit Ratings Waning Influence on the Market
The stock market (NYSEArca: VTI) seems to have long ago dismissed the self-importance and high esteem that credit raters still place upon themselves. 

Moody's announcement that major banks could face a downgrade filled headlines but didn't do much else. Bank stocks (NYSEArca: KBE) and the financial sector (NYSEArca: XLF) were already declining as they have been for most of this year.

The same thing can be said about the U.S. Treasury market (NYSEArca: TLT), which has rallied despite the threat of a credit downgrade.

Either the market doesn't give a rat's behind about the credit opinions coming from rating agencies or it already knows they're badly wrong - or maybe both.

Other Uncomfortable Questions
What if the U.S. government was an individual or corporation? Would it still be allowed to keep its triple A-rated status despite its decrepit financial condition? How bad is thedeficit? What kind of conclusion can be drawn from evaluating the government as if it were a corporation?

The ETF Profit Strategy newsletter examined the U.S. government's finances in its May 2011 issue, analyzing the government as if it were a corporation - the USA, Inc. By viewing the government's finances this way, it provides a more realistic view of the trueness of its financial condition versus relying on credit ratings.   

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs

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