Bond Rating Services and Toxicity

My father-in-law built planes for North American Aviation his whole life. On his desk he had a piece of wood with a message that read “quality must be built into a product, it can not be inspected into it.”

When I got into the municipal bond business in the late 1960's, there were two well known bond rating services that everyone used when discussing the quality of a bond. Now there are three. Bonds receive ratings based on their ability and willingness to pay their interest and principal in a timely fashion. These ratings start at triple-A and run all the way down the alphabet to a single-C.

I remember one day the bells rang out on the munifax wire and everyone ran over to the machine to read the news. As I remember it, and this was over 30 years ago, so my memory may be a little fussy, the general obligation bonds of New York City lost their single-A rating. Everyone knew the situation with regards to the finances of New York City was not good. It was not a closely guarded secret from the investment people on Wall Street, nor for that matter any other street. Even though New York City GO bonds carried an A rating, they sold as much as 175 basis points cheaper than any other piece of A rated paper in the municipal bond market. The next day the bells rang again, only this time the news was that the rating service that lowered the rating the day before had seen the light and was now restoring New York City’s A rating. New York City GO bonds continued to sell at a huge spread to other A rated GO bonds. The rating service change did not influence the muni bond market.

After New York City went into default on their bond obligations a few years later, several of the larger investment securities firms in New York created teams of municipal bond analysts to write reports on new issues of municipal debt. I used to receive these weekly reports and I read them. I will not go into what these reports said, as I figure by now, I have lost half my readers, and I don't want to lose the other half. This practice of producing research reports for municipal debt lasted for a few years and then slowly disappeared. Several firms produced these reports each week in a booklet formate. Each firm used a different color envelope to mail their reports. I would save these envelopes and use them to sketch on. I would take these large envelopes into meetings with me to sketch on so I would not fall asleep. Once a meeting lasted more than 60 minutes at the bank, my brain went on screen saver unless I started moving my left hand.

So, what's the point? The point is this, ratings and research are important, but not many are willing to put the money into it that is necessary to produce a quality product. Young analysts don’t make much money and they want to advance in their careers. The rating services don’t pay the big bucks that the investment banking firms do. As a result, the better analysts move from the rating services to the investment banking firms. Giving debt a AAA rating is a big deal in the credit world, or at least it used to be. US Treasuries are rated AAA, and that means something. When a mortgage credit is given a AAA rating, it better have the ability and willingness to pay at the highest level. A triple-A rating should not be taken lightly, it better stand for something. If ratings are compromised the whole system of credit ratings comes under a cloud.

The Fed can ease credit, lower interest rates and accelerate the growth rate of the money supply. But, the Fed can not wave a magic wand and bring investor confidence back to the credit markets if the credit rating system has been compromised. This type of crisis takes time to heal, and if it is a major part of the mortgage crisis mess, Ben Bernanke and God can not fix it overnight.

For all of you that have hung in there so far, I salute you. Tomorrow is another day. I will try to find something to reward you. Stay tuned.