Thursday, October 9, 2008
At The Vortex Of The Credit Markets
Individuals have credit scores. Anyone who has spent any time on their computer has seen ads about knowing your credit score. When people go to buy a house, their credit score is part of the information that is included in the application for a mortgage. Bonds and notes issued by states, counties, cities or authorities have a credit score too. Corporations that issue debt whether it is commercial paper, notes, or bonds have a credit score as well. Basically, the credit score tells a lender or investor the individual's, or the municipality's, or the corporation’s willingness and ability to pay back the money borrowed (principal and interest). When the credit score involves a corporation or municipality or an authority, the three major credit rating companies, Moody's Investor Services, Standard & Poors and Fitch do the credit analysis and assign a rating. These ratings start at the top with a AAA rating and move down to double-A (AA), then single-A (A). Moody’s then goes with Baa, Ba and then B, while S&P goes with BBB, BB and the B. Ratings go all the way to single-C and below. The system as it stands today can be improved, I do not think there is any question about that.
Years ago when I was working with bonds and bond portfolios, it was known that one way to improve the investment performance of a bond portfolio you managed was to do your own credit research. It was a known fact on the street that the rating companies were slow to act on new information. A portfolio manager could buy a bond that he thought might be in line for an up grade in rating before the rating companies actually up graded the corporation or municipality. By buying a bond that might be up graded, the portfolio manager could realize a higher market value for that bond after the up grade by the rating companies took place. A portfolio manager could also sell a bond that his research showed might be in for a down grade. The actual market value of bonds traded is based on their desirability: yield/ price.
The rating of debt instruments is a very important factor in the life of the bond markets. Without confidence in the rating process or the rating companies, the bond market grinds to a halt. If people buying gas had no confidence in the pumps they were using to pump their gas, what might happen? Confidence and trust in the fact that you are receiving a gallon of gas for your money is essential. What would people do if every time they put their credit card into the gas pump to pump gas, they got ripped off at the pump? What would happen to the trucking industry if truckers could not depend on receiving the correct amount of diesel they were paying for? Weights and measures and their accuracy are essential for commerce as it is for the financial markets as well. Getting short changed in one is no different than being short changed in the other.
Congress needs to take up this issue of rating debt instruments because it is at the vortex of what makes up the credit markets. I hope someone will explain this to them.