Debt rating alphabet soup can spell disaster

A firm with a nebulous business bestows an unintelligible string ofletters on a European economy and capitalism briefly grinds to a halt.

Makes perfect sense? Hardly.

Credit rating agencies came under firein Mayfor their role in Europe's widening debt woes, but few people understand exactly how the industry works much less what Baa+ is supposed to mean, for example.

The process itselfdates back to John Moody.

A self-taught investment guru at the turn of the 19th century, Moody published a book of his views on various stocks and bonds. Full of technical analysis that is commonplace today but was then ahead of its time, Moody's Manual of Industrial and Miscellaneous Securities proved popular with investors and quickly sold out.

When the stock market crashed in 1907, Moody's lacked enough capital to survive the downturn, so he had to sell his manuals business. Needing a new revenue source, he hatched the idea of selling an analysis not of individual securities at any given time but rather their overall credit-worthiness.

Essentially, he looked under the hoods of various debt instrument sellers, and gauged how likely they were to default on their loans, based on their payment history and the general state of their finances.

He borrowed the letter-based system of the mercantile agencies that monitored credit-worthiness of individuals (similar to credit agencies TransUnion and Equifax today) by assigning them a letter grade.

That system was arcane and obtuse to begin with, and Moody exacerbated the problem by adding new layers in between. AAA and AA were added to differentiate among the truly elite. Other companies quickly followed suit, often throwing in a + or - of their own, and by the middle of the 20th century, the obtuse parlance of Baa and A-3 was endemic.

"For Moody, A Triple-B is a B-double-A," deadpans Peter Bethlenfalvy, co-president of ratings agency DBRS Ltd.

"It's certainly not a perfect system but I'm reminded of that quote by Winston Churchill about democracy it's the worst form of government except for all the other ones that have ever been tried."

Although the agencies are always looking at waysof changing their methodologies, the old ways stick around. Fitch and S&P both rate good corporate debt A+ or A-. DBRS calls those A high and A low, while Moody's says A-1 and A-3.

They're also proprietary, which means every company is going to do things to differentiate themselves. "They're all pretty much the same," University of Toronto finance professor Allan White said.

Moody's and S&P track each other very closely, for example, even subscribing to each others services.

"If Moody's changes a rating, chances are S&P will do so, so I'm not sure I buy the theory that they're checks and balances on each other."

There can certainly be a herd mentality. When Moody's downgraded Greece and several debt-addled European nations in April (some would say too late, as Greek debt was trading as junk in the actual market weeks before an official downgrade) other agencies followed suit.

Once a country or company is downgraded, it's harder to secure financing. Higher lending costs make a country's precarious financial situation worse, which leads to more downgrades, and so on, and so on, starting a vicious cycle.

"Our sovereign ratings generally have performed as expected, and we continue to call them as we see them when credit quality changes," S&P spokesperson Chris Atkins said recently, but that's done little to dispel the notion that the agencies hold too much power and fail to ever stop crises before they start.

Much of the dodgy U.S. mortgage debt hidden in collateralized debt obligations during the subprime mortgage crisis was wrapped in a pristine AAA+ rating, so some say their opinions need to be taken with a grain of salt.

"It's not a terribly complicated business and they're not doing anything a reasonably diligent accountant couldn't do,"White says.

The industry is always looking at itself and changing the way it does business, but the system works because the professional market understands the definitions and factors that go into ratings, Bethlenfalvy says.

That's probably the main reason the seemingly confusing system lives on.

Demands for change

"I think everyone would agree there are problems," White says, and some say chief among them is how the industry gets paid.

Although the industry has worked on numerous pay models over the decades, the one that seems to work best and minimizes conflicts of interest is the current issuer-pay model, where the firms and governments issuing the debt pay agencies to rate them.

Investor-pay systems aren't ideal because there's less transparency and major investment houses who pay for the info tend to want to keep it a secret for a competitive edge, Bethlenfalvy argues. And there's an inherent problem in having someone pay to rate the value of an asset they themselvesown and may want to sell.

"It's like one of the parties in court paying the judge's salary, or one of the teams in a competition paying the salary of the referee," Michigan Democratic Senator Carl Levin said at a Congressional hearing on the agencies in April.

European regulators are pushing for new rules on the industry aimed at reducing conflicts of interest, andforcing them to disclose their methodology.

When the misery caused by Greece's ratings downgrade last week spread across Europe, regulators threatened to set up their own arm's-length body to handle sovereign debt ratings. In mid-April, the government of Vietnam did just that, banning independent agencies from rating Vietnamese bank debt because it didn't like the results.

"Europeans are saying maybe governments should do it, but let me tell you governments are some of the least transparent givers of information," Bethlenfalvy says. "They're very conflicted."

DBRS hasa number of safeguards in place to ensure that the analysis side is never influenced by how the company pays its bills.

Critics like White say it's hard to believe that the agencies would be willing to downgrade the rating on a company they depend on for a large chunk of their revenue.

Even if government-sponsorship isn't the answer, a further problem with the current system is that once the snowball starts rolling, it can be hard to stop. Average investors may not care that Spanish debt is now rated Baa- until it plays out on North American stock markets, or hurts the company they work for because it has extensive operations in Spain.

If more than one agency decides a country's word is worthless, under their own rules governments can be forced to shed the assets as collateral.

European Central Bank rules, for example, prohibit using government bonds as collateral if they are bestowed junk status by more than one agency. That would be disastrous for any country trying to dig itself out of a financial hole.

Ultimately, critics push for reform, but acknowledge they're unlikely to see any changes in an industry that's been chugging along for more than a century.

Says Bethlenfalvy: "It's not a great system but it's the best we've come up with."