Bond Rating Agencies: Conflicts and Competence

Martin Fridson

Journal of Applied Corporate Finance, 2010, vol. 22, issue 3, 56-64

Abstract: Faulty ratings of mortgage‐related collateralized bond obligations played a prominent role in the financial crisis of 2008. Some critics charge that the rating agencies did not merely make honest mistakes, but were hopelessly conflicted by their practice of collecting revenue from the bond issuers. According to the author, however, that same fee arrangement did not prevent the agencies from achieving considerable aggregate ‐level accuracy in other segments of the debt market. Given that the bad credit assessments were largely limited to structured finance deals, and that there appears to be no workable alternative to the issuer‐pay model, the best prescription for the agencies going forward is likely to be additional safeguards for situations in which the associated conflicts of interest appear especially difficult to manage. Also contradicting the testimony of many market participants, the author's analysis of new issue pricing and price changes suggests that the market generally views ratings on corporate and municipal debt as useful (if not always the most timely) indicators of risk. Moreover, the critics' favorite anecdotal example of rating agency failure, the Enron case history, turns out to be specious on closer examination. The standard account of Enron's collapse omits the fact that both Moody's and Standard & Poor's “watchlisted” the energy trading company and warned investors that its investment‐grade rating was contingent on a proposed acquisition by an investment‐grade competitor that failed (at the last minute) to close.

Date: 2010
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