Wednesday, November 16, 2011

The Mootness of Rating Agencies - Part 2

Not too long ago, I wrote about rating agencies are incentivized by incentives. This means that the credit ratings assigned are correlated with the amount the rating agencies get paid. The higher the rating agencies get paid, the higher the rating they will assign to the borrower.

Here is more evidence of the destructiveness of rating agencies:
West Haven, Connecticut, which has closed four school buildings over the past two years and fired 14 teachers to help cut its budget deficit, is about to pay Moody’s Investors Service almost double what it cost six years ago for a credit rating. 
Joseph Mancini, finance director for the city of 55,000 near Yale University, says he has no choice other than to meet the demands of Moody’s after the municipality’s bonds were downgraded to Baa1 in January, three levels above junk, from A2. 
“The market’s going to punish us for the rating we’re at,” Mancini said in a telephone interview. “If we didn’t get it rated, we would be punished even more.”
Connecticut is about to pay  double what it paid six years ago. The compounded growth is approximately 12% per annum. And one wonders why US corporate profits are at record levels. Here is why the rating agencies can exploit the borrowers:
“It’s very hard to convince someone to stop using S&P and Moody’s ratings because they’re such a market norm,” James Gellert, chief executive officer of Rapid Ratings, which charges investors rather than issuers for its grades, said in a telephone interview. “If you don’t have one, people will wonder what’s wrong with you.”
“There are very few businesses that have the competitive position that Moody’s and Standard & Poor’s have,” Buffett said. Berkshire is an “unwilling customer” of Moody’s when it issues bonds, Buffett said. “We pay for ratings, which I don’t like.” 
Moody’s raised its standard fee this year on corporate bond offerings to 5 basis points, or 0.05 percentage point, of the amount being raised with a minimum of $73,000, from 4.65 basis points in 2010, according to Michael Meltz, a JPMorgan Chase & Co. analyst in New York. S&P asks for 4.95 basis points with an $80,000 minimum, up from 4.75 basis points and a $72,500 minimum last year. It would cost $497,500 to have both companies evaluate a $500 million debt sale. 
S&P and Moody’s haven’t lost business as a result of their increases, said Peter Appert, an analyst at Piper Jaffray & Co. in San Francisco. 
“Pricing has no bearing on whether somebody is going to issue debt or not,” Appert said in a telephone interview. The extra interest a borrower would have to pay on an unrated bond is a “whole lot more” than the cost of a rating, he said.
And here is why rating agencies are a giant extortion scheme:
“They are extorting the cities of this country,” Frank said in a telephone interview. “By the criteria they use for the private sector, every full faith and credit municipal bond should be AAA.” 
Bonds from cities and countries are rated “more harshly” than those of banks and corporations, according to the academic study, which was released in August by Jess Cornaggia of Indiana University, Kimberly J. Cornaggia of American University, and John E. Hund from Rice. There’s “virtually no chance” of default on bonds backed by the ability to tax, Frank said.
Source: Bloomberg