1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Ravi Nagarajan
Ravi Nagarajan
Articles (5983)  | Author's Website |

Improved Credit Rating Firms Oversight Cannot Substitute for Investor Vigilance

April 15, 2009 | About:

The well publicized failures of the credit rating agencies in recent years was the subject of intense scrutiny today at the SEC Roundtable on Credit Rating Agencies today in Washington DC. The four panel discussions included the leaders of the major credit rating agencies, representatives of firms consuming the data provided by the ratings firms, prominent academics, and government officials. SEC Chairman Mary L. Schapiro summed up the sentiment of many consumers of rating agency data in her opening remarks:

The status quo isn’t good enough. Rating agency performance in the area of mortgage-backed securities backed by residential subprime loans, and the collateralized debt obligations linked to such securities has shaken investor confidence to its core.
Of course, there were many other blatant errors including the fact that American International Group (AIG) retained a AAA rating all the way up to the events of September 2008 which led to the Federal Government’s massive infusion of taxpayer aid at AIG. It is fair to say that the major rating firms have very little credibility left today which is an obvious problem for companies who trade in the soundness of their analysis and opinions.

Reforms Not a Total Solution

One of the central points in recent discussions involves compensation models and conflicts of interest that can occur under various scenarios. It is very likely that some major reforms are needed in several areas given the inherent conflict of interest that exists when a ratings firm is being paid by the companies under scrutiny. While having the users of ratings information compensate the credit rating firms may reduce this conflict of interest, no reform measure will relieve those ultimately responsible for security selection of the duty to conduct thorough due diligence directly rather than abdicating this responsibility to the credit rating firms.

Going Back to Graham and Dodd

Rather than delving into the specifics of the various reform proposals under discussion, a more productive line of inquiry involves questioning the over-reliance on the credit rating agencies and the abdication of responsibility on the part of users of the ratings data. Individual investors, professional money managers, regulators, and others came to consider a company’s credit rating as sacrosanct rather than merely an opinion. Even if one assumes that the credit rating firms are employing highly talented individuals, and even if one assumes that there are no conflicts of interest, is it wise or prudent to take their opinions as the last word on the subject?

I seriously doubt that Benjamin Graham would have thought so. Those who have read Security Analysis know that Graham always insisted on relying on primary sources of information rather than compilations of data or the opinion of analysts. By primary sources, I am referring to SEC filings, industry publications, trade journals, interviews with management, and other data collected by the analyst personally and upon which a conclusion is drawn regarding the credit-worthiness of a particular security. Here are some excerpts of what Graham had to say on this matter in the 1940 edition (page 97):
Most of the information required by the securities analyst in his daily work may be found conveniently and adequately presented by the various statistical services. … These services have made great progress during the past 20 years in the completeness and accuracy with which they present the facts. Nevertheless they cannot be relied upon to give all the data available in the various original sources… Some of these sources escape them completely, and in other cases they may neglect to reproduce items of importance. It follows therefore that in any thoroughgoing study of an individual company, the analyst should consult the original reports and other documents whenever possible, and not rely upon summaries or transcriptions.
Abdication of Responsibility

But isn’t this exactly what the rating agency analysts are supposed to be doing on behalf of investors? One can make that claim, particularly if compensation models change such that the users of the ratings are compensating the agencies directly. Investors are relying on the agency analysts to examine primary sources in detail when arriving at their conclusions. Obviously any analyst is human and can make mistakes whether the analyst is the investor committing his own capital or someone hired to perform this work for the investor. However, the ultimate responsibility for the safety of capital is the investor making the commitment of capital whether we are talking about an individual investor or a financial intermediary entrusted with an investor’s funds.

In many cases, it may be easier for an institutional investor to hide behind the rating agencies when investments turn out badly. After all, if all of the rating firms thought that AIG was a AAA credit, how can one fault an individual portfolio manager for not noticing the problems? Looking at this from another angle, would it have been easier for a portfolio manager specializing in mortgage-backed securities to go along with the vast majority of his peers and consider the toxic securities to be AAA credits or to give up potential yield (however illusory) by opposing the majority and refusing to participate?

Widespread Implications

Of course, the ratings these firms come up with have much broader implications than simply assisting investors with the decision of whether or not to commit funds to a specific security. Rating decisions can have direct impacts on the economics of a business since contractual commitments can change in the event of a downgrade. This can include the requirement to post additional collateral on derivatives transactions among other things. In fact, this threat was one of the major reasons for the government intervening in the AIG debacle last year.

More recently, it appears that the credit rating agencies have taken a much more risk averse posture with respect to Berkshire Hathaway. I wrote about the actions taken by Fitch Ratings, Standard & Poor’s, and Moody’s in recent weeks along with some of the problems I observed in the logic behind the moves. While the ratings firms were blind to risk during the boom years, it seems that they are now equally irrational in terms of risk aversion.

Regardless of the outcome of the reform discussions currently underway, investors would be well advised to remember Graham’s advice and consider themselves to be the final authority on judgments regarding the safety and soundness of security selections rather than abdicating this most fundamental responsibility to any third party.

Ravi Nagarajan


About the author:

Ravi Nagarajan
Ravi Nagarajan is a private investor and Editor of The Rational Walk website. Ravi focuses on applying value investing techniques to find securities trading well below intrinsic business value. Ravi has over 15 years of experience in the financial markets and started investing on a full time basis in 2009. From 1996 to 2009, Ravi held a number of technical and executive level positions in the commercial software industry. Ravi graduated Summa Cum Laude from Santa Clara University with a degree in finance. Visit his website The Rational Walk

Visit Ravi Nagarajan's Website

Rating: 3.3/5 (7 votes)


Please leave your comment:

GuruFocus has detected 1 Warning Sign with Moody's Corporation $MCO.
More than 500,000 people have already joined GuruFocus to track the stocks they follow and exchange investment ideas.

User Generated Screeners

evseanLow Value Stock II
jpraschnikGreenblatt - Magic Formula
pbarker46Shiller PE
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)