Credit Ratings

Many savers with a 401(k) or other investment account are probably familiar with the Standard & Poors, Moody’s or other credit rating firms. Monthly statements usually include their ratings alongside a list of assets.

Lately though the credit rating firms have admitted to Congress [Washington Post, Credit-Rating Firms Grilled Over Conflicts, October 23, 2008] their ratings have been tainted by conflict of interest. Moody’s and Standard & Poors are paid by the firms they rate. The article quoted a memo written at Standard & Poors by someone who said "Let’s hope we are all wealthy and retired by the time this house of cards falters."

Long before I read that anonymous statement I wondered about credit ratings and whether they are good guides for savers and investors. Credit rating firms use past performance to rate future risk.

Forecasting the conditions in markets years ahead is hard enough but the current wave of defaults on mortgage backed securities has spread to other firms in a domino effect. The good management and triple A rating at one firm can be affected by defaults at other firms. Ratings cannot be given in isolation from the solvency of the larger financial system.

Since a bond is an enforceable contract just like a home mortgage, it is worth asking whether a failure to pay interest and principal on time is the important financial risk. As long as a defaulting institution remains after a default, then late payments can be recovered later.

For example, corporate bond holders risk losing interest and principal in a default, but a corporation can literally disappear in a bankruptcy. Cities, counties and states do not disappear. Even if they go into default they continue to have taxing authority to meet their legal pledge of full faith and credit to pay their bond obligations.

Furthermore, city and county governments are created and governed by state legislation, which makes state government responsible for city and country bond payments in the event of their default.

Following this logic, even small municipalities should have higher credit ratings than private sector corporations. Size and name recognition should not matter in credit ratings and the difference of market interest rates between government and corporate bonds may not reflect actual differences of risk. Remember too non-federal government bonds and bond funds are not taxed as part of income.

The article did not tell readers if Congress wants to impose professional standards, or what if anything it intends to do about this newly reported conflict of interest. In the mean time, remember governments are likely to be around to pay their bills.