Where All The Bonds Are Investment Grade

Welcome to Lake Wobegon, where all the children are above average – and all the bonds are investment grade.

Okay, probably not. Yet until a child runs amok on the northern prairie, perhaps by going on a cow-tipping rampage or by driving the John Deere into a famous fictional lake, who can say that any particular youth – along with every one of his or her classmates – is not truly better than the norm? “Average” is a mathematical fact, but rating is a matter of opinion.

We all tend to overestimate ourselves. Ask us individually, and most of us are better drivers, cooks, friends, workers and lovers than most of the rest. Collectively, this is impossible, but individually, we are convinced it is true. Psychologists call this the Lake Wobegon effect.

The fact that so many of us are wrong does not mean we are behaving in bad faith. We truly believe we are that good. (This is not to make excuses for the fellow whose online dating photo closely resembles George Clooney but who in real life is closer to being the doppelganger of Elmer Fudd.) There is a big difference between an opinion unsupported by objective fact and a lie.

Which is why we have to wonder how Standard & Poor’s finds itself in court defending its opinions against allegations of fraud, and on the front page of The New York Times in an article asserting that S&P is giving securities higher ratings than its competitors give in order to win more business.

Back in February, the Justice Department targeted S&P in a civil fraud lawsuit. S&P fought to have the case thrown out, arguing that “the company’s statements about the integrity of its rating process [were] mere ‘puffery,’” and that such corporate boilerplate is protected under the First Amendment. Recently, however, U.S. District Judge David Carter allowed the case to go forward, ruling that S&P’s statements about the objectivity of its ratings “stand in stark contrast to the behavior alleged by the government’s complaint.”

S&P also faces several additional state lawsuits, which have been consolidated in Manhattan federal court, and a California False Claims Act lawsuit. All of the litigation centers on ratings S&P assigned to various credit products whose values were hammered when housing prices fell and financial markets imploded five years ago.

S&P was not alone in issuing high ratings to securities that later either defaulted or became devalued, but it is alone in being sued by the U.S. government – just as it is alone in rating U.S. government debt at less than AAA. The Justice Department, of course, does not acknowledge any connection.

At this point, I don’t understand why S&P continues to offer ratings on U.S. Treasury securities at all. No other U.S. rating agency ought to be rating Treasury obligations either. Such ratings have no credibility when the Justice Department sends the message loud and clear: You could be next.

The government’s lawsuit against S&P threatens the economic rationale for the entire credit rating industry. Lest CPAs think they have no dog in this fight, the lawsuit and its implications threaten the basis of the auditing industry as well. Audits, like credit ratings, are opinions expressed on an entity’s financial condition. They are not Delphic predictions of the future. They are not insurance policies. They are not guarantees.

S&P promised objectivity and independence in its ratings. In its unsuccessful challenge to the Justice suit, it argued that no reasonable investor would rely on what is essentially marketing copy for the firm. That position certainly must have been embarrassing for S&P to have to argue, but it has a large element of truth.

There is a built-in conflict of interest in the entire financial opinion industry. The problem is that the entity on which the opinion is expressed is the one that hires the party who expresses it. There is always going to be a suspicion that the opinion-givers refrain from being unduly strict, lest they not get any business in the future. This is the gist of The Times’ story asserting that S&P is deliberately giving higher ratings than its competitors, so it will be hired more frequently.

It is possible that this is true. It is also possible that S&P believes the credit-rating industry overreacted to the market disaster of five years ago, adopting excessively conservative standards for evaluating the future risk of trouble. After all, homes rarely burn down after being struck by lightning. If your home happened to be hit, you would not expect your insurance company – after paying to fix your house – to raise your rates because it suddenly thinks lightning is likely to strike again.

In any event, one rating company’s ratings are not directly comparable to another’s. The underlying premise of The Times’ article is that they are.

Consider two teachers, or two movie critics. Each assigns top, middling and failing grades according to their own standards. If a critic gives one film three thumbs up and another 2.5 thumbs, it is clear that the critic liked the first film better. But if one critic gives a film three thumbs up and another gives that film 2.5 stars, we know nothing about which critic liked the film better, and certainly nothing about which one is right. The second critic may just be stingier. In any case, critics’ opinions are just opinions.

So are bond ratings.

If lawsuits like the Justice Department case against S&P are successful, companies are going to need to ask themselves whether they want to be in the opinion-giving business at all. If the answer is yes, the model may have to change. The parties that rely on credit raters and auditors may need to start hiring them directly, rather than leaving it to the parties such opinion-givers examine. The result will be far fewer opinions, available to far fewer parties, and not available at all to parties that lack the very deep pockets necessary to pay for such detailed financial reviews.

Do we want an imperfect system of financial opinion provided by third parties whose independence is potentially (or in some cases actually) compromised? Or would we prefer, effectively, no opinions at all?

It’s a fair question. It is one the Securities and Exchange Commission has been struggling for three years to answer, since the Dodd-Frank legislation directed the SEC to come up with a better approach to delivering credit ratings. (This is yet another Dodd-Frank requirement that sounded good to legislators as a theory, but which is proving unwieldy when administrators try to put it into practice.)

Here’s an idea: Why don’t we let the government issue credit ratings? If Justice Department lawyers think S&P’s ratings are lies, they can pick the raters they are sure will tell us the truth. Certainly, the objective analysts in the federal bureaucracy would never buy into that everyone-is-better-than-average stuff.

Well, except for the one who evaluated Solyndra.

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