After the carnage of the 2008 financial crisis was over, a lot of finger-pointing among the major Wall Street players ensued in an attempt to assign blame for a catastrophe that few saw coming. One of the prime targets in the fiasco were the staid bond rating firms: Standard & Poor’s, Moody’s, Fitch and a few lesser-known entities. The opprobrium directed at their lax standards for assessing credit risk was well deserved.
In hindsight, it was apparent that the high credit ratings assigned by these bond analysis firms to some of the securitized tranches of home mortgages grossly understated or ignored the risks associated with these novel debt obligations. The investors who relied on these ratings as a basis for purchasing these instruments suffered great losses and the reputations of the reporting agencies were tarnished.
Recently, the ghost of credulous default risk ratings has reared its head once again. In a quest to enhance market share, many firms are issuing ratings that minimize the risks to investors who purchase the debt instruments of various corporate issuers.
This baneful ratings process is reminiscent of the scandalous conflict of interest problems that plagued the accounting industry over 15 years ago, which caused the dissolution of Big Eight accounting firm Arthur Andersen and led to the enactment of the Sarbanes-Oxley Act.
Even though the credit ratings themselves may be suspect, many investors continue to rely on the risk assessment assigned by these firms. Federal Reserve Chairman Jerome Powell has, on numerous occasions, made no secret of his concern about high corporate debt levels and unreasonably high credit ratings.
During a May 2019 speech, Powell likened one of the hottest debt instruments today, collateralized loan obligations, to pre-2008 crisis mortgage-backed debt. As Powell noted, “Once again, we see a category of debt that is growing faster than the income of the borrowers even