Most people would agree ratings agencies had something to do with the housing boom and bust. Raters slapped investment-grade ratings on debt that was anything but investment-grade.
Then the housing market blew up. The Great Recession unfolded. We all know this story. Ratings agencies drew some criticism, and some argued the industry had too much power. Not all that much has changed, though – ratings agencies still run the world.
The Worst Combination
There are only three major credit ratings agencies – Fitch, Standard and Poor’s, and Moody’s. All three are responsible for rating the overwhelming majority of publicly-traded debt issued by businesses or governments.
The ratings agencies carry incredible clout, but not just in their ratings. In fact, I’d say their ratings are just a minute detail compared to the true power they have: influencing indexes and the movement of investment capital.
It takes two to tango. Bond indexes use rules-based systems in which two investment-grade ratings propel a company’s debt to investment-grade indexes. The agencies provide the ratings, which are used to select component debt issues.
How Ratings Agencies Control the World
Ford Motor (F) recently earned investment-grade ratings from two agencies, giving us the opportunity to test the power of the big three. While solidly in junk status, Ford Motor bonds paid investors 3.99% more than US Treasuries of the same duration.
One month and one upgrade to investment-grade later, Ford bonds offered a yield only 2.38% higher than US Treasuries. Less than three weeks later, Ford received another investment-grade rating, meaning its debt would join popular bond indexes. Ford’s debt yields plummeted to 1.89% the same day it happened.
Let’s make something very clear: there were no fundamental changes to the business during this two month period.
Ford’s credit rating was the only variable – two investment-grade ratings meant Ford could join popular bond indexes. Yields on Ford debt plummeted by 2.1% in less than two months, a huge change based only on what two companies thought of Ford’s creditworthiness.
The Most Valuable Rubber Stamp
The ratings agencies wield the world’s most powerful rubber stamp. When you look at a firm like Ford Motor Company, which has long-term debt of more than $100 billion (most of which comes from its auto financing arm), a stamp of approval from the ratings agencies is worth $2.1 billion per year to the firm when it refinances all of its debt at a lower rate.
It all comes down to the way asset management works. An analyst who spoke to Bloomberg said it best, “Most fixed-income guys are mindful of what index they’re being measured against.” To put it more directly: asset managers had to buy Ford debt to keep the pace with their index, all because the ratings agencies bumped up the company’s credit rating.
Relate this to your own finances. Imagine for a moment that, with no change in your financial standing, your credit score were to go from 550 to 700, and you were able to refinance an existing mortgage at a 2.1% discount to its original interest rate. It’s insane, but it is what it is – credit rating companies in every industry carry incredibly clout.