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.

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.