For the big three credit rating agencies, growing criticism last 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 isn't the first time the agencies have found themselves under pressure. The beleaguered industry got similar complaints after the collapse of Enron Corp in 2001, and before that the bankruptcy of Orange County, California, in 1994.
In all three situations, ratings assigned to these issuers went from near-stellar to junk almost overnight. As the agencies begin to think about changing the way they do business, analysts say investors must become more vigilant about what debt securities they sink money into -- and not rely solely on what the rating agencies say.
VIGILENCE NEEDED
"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," he said.
Investors are plowing more money than ever into fixed-income products, from municipal bonds to exchange traded funds. The Securities Industry and Financial Markets Association, a New York-based trade group, says outstanding public and private debt underwritten by bonds was valued at about US$25 trillion.
About 10 percent of corporate bonds are held by individual investors, while institutions like pension funds hold the rest, according to the group.
These securities are an integral part of retirement planning and diversifying portfolios during rocky times in the equities market.
Fridson and others say most investors don't hold the kind of opaque asset-backed securities that caused global banks to lose about US$130 billion since last year. However, there are certain tip-offs investors should watch for when investing in the fixed-income markets.
SKEPTICISM HELPS
For instance, he said "one sure guide is to be skeptical if you see something yielding much more than comparably rated bonds."
"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 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. Debt issuers seek out higher ratings because that makes it easier to raise money in the capital markets.
The agencies have already taken some steps to deflect such criticism and ease mounting regulatory and government concerns.
S&P said last week that 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 if the industry will begin to shift to other rating models.
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