Credit raters come under scrutiny

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 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.”

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. However, 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 – like 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.

And 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 through measures ranging 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, it 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.

“There are people out there right now trying to figure out how to build a better mousetrap,” Flahive said. “If I was John Q. Public, I wouldn’t feel overly better – it is going to take more than a few alterations to how the rating agencies are doing things.”