This Week In Finance

"What do Ratings Mean?"

After teaching the undergraduate Financial Management course for nearly 20 years, I find that I can generally anticipate many of the questions that will be asked. (Although I do get surprised from time to time.) Nonetheless, nearly every semester, students are surprised to find find that corporate bond issuers pay the major ratings firms to issue ratings on upcoming debt issues. (For the moment, I will set aside the "unsolicited ratings" brouhaha of a few years ago.)

Anyway, two issues generally arise in this context. First, students often ask, Why don't firms just issue unrated debt, which would forego the cost of the rating and avoid the possibility that the resulting rating will be less favorable than hoped for? And second, to the extent that the issuing firm is paying for the rating, isn't there an incentive for the rating agency to "play along"?

I use my answer to the first question to hammer home (again) the information asymmetry issue (which I raise when discussing the first chapter of the text, and agency costs in particular. Investors, being risk-averse and generally suspicious will view an unrated bond as inherently more risky than a rated one, all else equal. Lack of a rating suggests (at least) two possibilities: the firm can't afford to pony up the agencies' fees (unlikely, but troubling, nonetheless); but more importantly, information exists which the issuing firm's managers don't wish to have disclosed, either explicitly, or implicitly via a low rating. In either case, rational investors will require a higher return on the issue, making it more costly to the issuer and possibly more difficult to sell. In short, the cost of a rating is more likely to be "worth it" than not from the issuer's viewpoint.

What about the perverse incentive created by the act of paying for ratings? I was reminded of this question recently by an item in The Wall Street Journal of Wednesday, October 28. In an article entitled "S&P, Moody's Plan to Rate Funds," the Journal notes that the "big two" bond rating agencies are developing mutual fund rating products and services in order to "diversify their business lines and expand into the $4.7 trillion [!] mutual fund business." The article goes on to say that "Standard & Poor's, which is further along in the process, also will consider the fund company as the ultimate client, and it will charge fund firms that want to use the new S&P ratings in advertisements and promotional materials."

What is particularly interesting is the response of John Rekenthaler, research director at Morningstar, Inc. "We don't see them as competition. It is difficult to have credibility when you say this fund is good after the entity paid for the rating."

Pose the following questions to your class. If a paid rating is, by definition, tainted or, at least, suspect, why is so much credence placed by investors in bond ratings? Just what is it that Moody's (or S&P or Morningstar) have to sell, but their reputations for objectivity? Is it likely that the agencies jeopardize their reputations in the financial markets (and, therefore, their long-term viability) for the sake of a few dollars? Why, that's no more likely than a President who would jeopardize his reputation for a few moments of pleasure with . . . oops, we probably don't want to go there. Anyway, the point is that questions like these are likely to generate some interesting discussions.

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