Blame Everyone. Accept No Blame.

I find this almost funny at this point; comical, really. Moody's, who suggested that their triple-A ratings collateralized-debt obligations (CDOs) may have been incorrectly assigned due to a computer error is now ousting some employees along with an announcement that some may have violated internal policies to award unwarranted investment-grade ratings on constant-proportion debt obligations (CPDOs). Moody's has suffered a substantial hit to its credibility, to be sure, but do such tactics really work to reverse public opinion?

The media holds a very influential position in that it is often able to sway opinions in the general public. In this case, however, you're talking about a very specialized group with an intimate understanding of the companies involved and the business of credit ratings. Does media rhetoric really affect the opinions of investors who understand enough to question Moody's credibility in the first place?

More Information Is Always Better

There's a lot of talk about the SEC and its persisting investigation of the ratings agencies. The good news is that, at least it appears at this point, investors will be winners now matter what the outcome.

I wrote earlier about the SEC's consideration of a plan to require the ratings agencies to make their research material available to others. This, of course, would allow others (hopefully individual investors as well) will be able to assess risk-and-reward profile for a given investment - just as the credit ratings agencies do. The advantage is that investors could become less reliant on the AAA-ratings and could review the actual data that goes into such a rating. With the agencies being blamed for having rated mortgage-backed securities as tripple-A (the highest investment-grade rating) that subsequently defaulted and resulted in hundreds of billions of dollars in losses and write-downs.

Now, there's news that the SEC will offer the ratings agencies a choice between two possible outcomes. The first, will be a disclosure of the underlying information as I described above; the second will introduce a new rating scale that would help identify mortgage-backed securities and distinguish them from corporate bonds. While certainly not providing as much information, this too would work to make investors more aware of where they were placing their money and that's never a bad thing. So, no matter what happens, at least its comforting to know that we, lowly investors, will ultimately win.

Ratings Agencies & Structured Securities

The SEC's investigation of the ratings industry continues and the latest target on their hit list is the rating of structured securities. The headlines suggest that the Commission may go so far as to ban the three top ratings agencies. Moody's, the S&P and Fitch from rating such securities at all. All three of these firms help to advise investment banks on the design of such securities, so how can they be trusted (by investors) to also provide impartial evaluation of their risk-and-return profiles?

What's more interesting, and possibly valuable, to investors, however, is the SEC's suggestion that the ratings agencies be required to make available all the data that goes into the ratings so that other firm (and possibly private investors?) be able to make their own determinations based on the very same information. In my previous studies about statistics we were often presented with research papers that claimed one result or another based on some analysis. What I often found quite interesting, however, was when such papers were later refuted by further analysis of the same data by other analysts.

As is often said, statistics can be massaged to say almost anything that you want. I can't help but think that ratings agencies are simply statistical analysts with an especially bring spotlight on their research reports. Data mining, the practice of scouring through numbers to find a particular trend or pattern, is a well known practice; try it for yourself. If you use enough data, I promise you that you can find any patter or trend that you want to find if you look hard enough and make the 'appropriate' assumptions. I think that the skill to analyze data yourself is invaluable and the news that more data may be made available to the public at some time the future will only help individual investors willing to put in the time and effort to make up their own minds about an investment.

Ratings Agencies Screw-Up & Get Paid Anyway

With all the economic trouble that has resulted from the sub-prime debacle, a great deal of attention was paid to the ratings agencies that awarded high ratings to the debt instruments that later collapsed. In its investigation of the factors that led to this collapse, the New York Attorney General, Andrew Cuomo, also began an investigation into the credit ratings agencies themselves and a settlement in that investigation was just reached between the state and both Moody's and Standard & Poor's. That settlement, however, may leave some investors scratching their heads.

As usual, of course, no one admitted any wrongdoing. You may recall that I previously wrote that Moody's was quick to suggest that a computer bug had caused the ratings to be inflated in certain situations and it never assumed any of the blame otherwise. What is interesting about the settlement, however, is that it may mean greater revenues for these ratings agencies going-forward - yes, more money! The reason, however, actually makes sense.

It all comes down to incentives. Just as the top CEO's have a large part of their total compensation packages tied-up in stock options that align their interests with the performance of the company's earnings (that, of course, is a whole other story), the ratings agencies will be paid for initial analyses and assessments performed on new sub-prime issues. Currently, prior to the new rules, the ratings agencies were paid only if they were ultimately selected by the issuer as the final, official, ratings agency. This approach, of course, incentivized the agencies to give better ratings than they might have otherwise in order to win the business. Being able to earn some cash regardless of their ratings, therefore, should make them more willing to speak the truth ...of course, I'm not saying that they haven't been doing so in the past... you understand, right?

It Wasn't Us; It Was The Computers!

That's what Moody's appears to be saying, or at least laying the groundwork to say, in light of the many law suits that are waiting in the wings spurred by the collapse of so-called Aaa-rated securities. One of the biggest head-scratchers with the financial crisis has been how such high credit ratings could have been issued on securities that were so susceptible to default; with news that Moody's is now investigating a possible computer bug that caused the mismatched ratings, it certainly does look as though it's covering its proverbial ass.

Both Moody's and S&P only began to strip-away their previously issued triple-A ratings after some of the constant proportion debt obligations (CPDOs) defaulted. Are we to think, then, that S&P's rating system was inflicted by the same virus?

CPDOs are portfolios of index-based credit default swaps (CDSs) that include both risky and safer trenches that have, somehow, made them candidates for the highest investment grade ratings. These CPDOs represent the latest innovation in one of the largest markets - credit default swaps - allowing investors to collect even higher returns as a result of even higher leverage. From this short description alone, does it sound to you as though this would qualify as deserving a Aaa rating? When will investors learn that there's no free lunch; higher rates of return do necessarily mean higher assumed risk. Period.

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money-market rates combined with the highest credit ratings -- described a ``holy grail'' for investors by Bear Stearns Cos. strategist Victor Consoli in a November conference call.

There's no holy grail; if there were, every investor, their brother, their sister and their cousin's nephew would be buying and the price of such assets would rise and thereby reduce its yield. It's a classic arbitrage opportunity that just can't exist for any extended period of time. If a broker or advisor is telling you differently, then they themselves probably don't understand the securities.

Here's a bit of a primer on CPDO's and credit default swaps from this bloomberg article:

CPDOs sell contracts on credit-default swap indexes and use the premiums to pay investors. If the perception of credit quality deteriorates, the cost of insuring the debt increases and CPDOs lose money. To make up for losses, the funds would typically increase their borrowing.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Rating a CPDO involves making assumptions about the way the indexes of credit-default swaps will move, based on a limited history of the benchmarks. The U.S. index referenced by CPDOs was created in 2003; its European counterpart started in 2004.

Does a AAA rating still mean what it used to?

I've written before about the growing concerns over the reliability of analyst reports on the companies in which we all invest, but there is something to be said for the information available to the analysts as well. Mood's and Standard & Poor's, the two largest ratings agencies, hold an incredibly influential place in the market; it is based on their evaluation of a company's ability to repay its loans that it assigns its ratings with a triple 'A' rating representing the least risky investment. Of course, when the companies bearing this esteemed rating begin to show signs of diminishing creditworthiness, shouldn't the ratings move in tandem?

The answer appears to be no. When the two largest bond insurers, MBIA and AMBAC - insuring more than $1 trillion dollars in debt between them, began writing down hundreds of millions of dollars in losses resulting from collateralized debt obligations and other mortgage-backed securities, neither ratings agency showed any sign of concern. Fortunately for both these insurers, that meant that they could each turn to the capital markets to raise new funds at the lowest possible rates. But what about the lowly investor relying on these same ratings to judge the risk of purchasing a bond?

Unfortunately, there is no simple answer. The un-simple answer is that investors should never rely too heavily on a single source of information. Yes, I'm afraid that needs to include even the most respected ratings agencies in the business. So far, there is nothing to indicate that they haven't acted responsibly. After all, neither MBIA or AMBAC has defaulted on its own obligations and that, ultimately, is what a lower rating would tend to indicate is more likely to occur. Then again, as the saying goes, it's better to be safe than sorry.