Bond markets around the world could be shaken by the outcome of the U.S. Department of Justice’s (DoJ) charge of civil fraud against the largest credit-rating agency on the planet, Standard & Poor’s Financial Services LLC (S&P) of New York. At issue is the credibility of the ratings S&P bestows on debt issues, as issuers pay S&P hefty fees to evaluate their debt. The question raised by the lawsuit is whether the ratings are reliable, given the way S&P is paid.

The worth of virtually every bond sold is at stake.

The DoJ filed charges against S&P on Feb. 4, accusing the firm of puffing up its ratings to please investment dealers that securitized dubious subprime mortgage investments, which created the foundation for the massive capital markets crash of 2008.

The essence of the DoJ’s case is that S&P allegedly abandoned arm’s-length prudence to turn dubious debt issues into the AAA-rated debt that many institutions wanted for their clients’ portfolios. This is the first major federal fraud action against the credit-rating industry, which is dominated by well-known names such as S&P, Moody’s Investors Service Inc. and Fitch Ratings Ltd., both also based in New York, and Toronto-based DBRS Ltd.

In 2008, the models used to predict default were based on the concept of “non-covariance”: the theory that mortgages issued in Utah, Vermont, Wyoming and New York could not flop in unison. Subprime mortgage debt that issuers sold to investment dealers was dissected into payments due on given dates, then structured into tiers, with the top level getting paid before any money would go to the next level, and so on.

Several dozen tiers down – informally known as “toxic waste” – the probability of full and timely payment was low, but so was the price of those bonds. Extending the idea of preferential payment at top tiers, the junk tiers eventually were knitted into new “collateralized debt obligations” (CDOs), called CDOs2, with top levels of junk getting paid first and, thus, getting high ratings. There even were CDOs3. The math made it work; common sense, however, prompted raised eyebrows.

“You cannot ignore the problem of objectivity,” argues Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “The bond issuers pay the [credit-rating agencies]. The agencies say their work and their conclusion are just opinions. If they are wrong, investors are penalized or the bond issuers are penalized. The model does not penalize the [agency].”

In turn, the credit-rating agencies say they are diligent and, indeed, they downgrade bonds with frequency. Cases of turning sow’s ears into silk purses of the sort that the DoJ alleges S&P committed are probably rare. What’s more common is that a borderline credit, such as a company deserving a BBB rating getting rated BBB+. Even a small notch up in ratings can save the issuer millions in interest costs and, just as important, get the bond qualified for institutional mandates that do not allow portfolios to hold debt below a specified rating.

Pension funds and insurance companies, as well as bond advisors and managers, often dismiss the work the credit-rating agencies do, preferring their own in-house research. Says Richard Usher-Jones, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont.: “We have 19 people doing credit research at Canso; and so, we don’t rely on external rating agencies. We have the research horsepower to do the work ourselves.”

That’s not the case for the infrequent bond buyer, such as retail clients and their advisors, small credit unions and trust fund managers. Without the practised eyes of specialists in utility bonds, railway offerings, bank debt or municipal financings, they may not spot weak points in bond offerings.

Infrequent bond investors and their advisors are up against experienced bond traders who have superior knowledge. Unlike stock trading, in which one share of a company is identical to another, each bond issue from a company may be unique in liquidity, covenants and rank within the issuer’s capital structure.

Says Robert Follis, managing director and head of corporate bond research with Scotia Capital Inc. in Toronto: “If you cannot rely on the rating agencies or do not have the capacity to do your own research, then the solutions are: to leverage off the skill set of others; to use managed products, such as mutual funds managed by experienced people; or to diversify in a broad [exchange-traded fund] for which the market has set pricing and diversification reduces the risk that any bond has been misrated.”

Having a credit-rating system in place is vital to the bond market. But if issuers don’t pay for the ratings, who will? Few bond buyers will pay on their own to rate bonds. If they did, they would have less money to invest. Every bond shopping trip through the market would have a price tag attached. Small buyers and advisors could be shut out in this process. That’s not what investors want, what governments that have to fund debts want or what bond issuers want.

In the end, the U.S. litigation will probably lead to more ambiguous wording in credit-rating agencies’ disclaimers. But third parties’ ratings paid by bond issuers can’t be replaced until there is a better model.

And that, Follis says, would require institutions, which are the biggest buyers, to change their rating guidelines: “There is no way to do away with the rating agencies. Most of what the agencies do is good.”

© 2013 Investment Executive. All rights reserved.