Commentaries

Investors ignore ratings at their peril

    Rexam is delivering a nasty surprise to its shareholders, but the logic of its proposed rights issue is hard to fault.     If trading turns out to be as bad as the board expects, then the penalty payments for refinancing its existing debt will far outweigh the cost and dilution of the issue.     Broker Oriel Securities reckons the cost to Rexam if it loses its investment grade rating will be an extra 8 to 12 million pounds a year in interest payments.     Businesses everywhere are rediscovering the joys of equity, as the way to stave off the dreaded downgrade. So far this year, shareholders have put up $119 billion, according to Thomson Reuters data, with $28 billion more due.     Even cash-rich carmaker Volkswagen is reported to be considering issuing shares to bolster cash reserves and pre-empt any ratings downgrade relating to its merger with Porsche. Spanish utility Iberdrola and French construction groups Lafarge and Saint Gobain all took similar steps to bolster their ratings.     Unfortunately, credit ratings agencies are so jumpy about regulators and the risks of legal action by investors that companies can’t always bank on such moves working.     Saint Gobain launched a rights issue, but still S&P cut it to BBB from BBB+. Lafarge did worse. Fitch not only cut its rating to BBB-, it added a “negative outlook”.     One reason ratings have increased in importance is that as banks have turned off the taps, companies have turned to the bond markets, allowing the agencies like Moody’s Corp and McGraw-Hill’s S&P to cash in.     Experience has taught them caution, however, and the number of issues downgraded from investment grade to junk is on the rise. The threat of this — with the higher cost of borrowing and reduced market access it brings — is a powerful incentive to go to the shareholders. S&P has identified 75 issuers — with $255 billion of debt — in danger of losing their coveted investment grade.     The unhappy experience of Rexam shareholders is likely to repeated many times as the debt crisis unwinds, but at least it’s better than losing control of the business to its lenders.

Breaking the credit ratings habit

How many times do investors need to rail against rating firms’ credibility before things really change? Standard & Poor’s set off the most recent round of vitriol on Tuesday after it raised the ratings on bonds backed by commercial mortgages back to sterling AAA just a week after it cut them. It tweaked its assumptions after investors complained about the downgrades.

There’s good reason to be upset. Ratings changes still have real world consequences, even though the credit crisis has gone a long way to discredit them.

As much as investors want to ignore ratings, ridicule them or simply shake their heads at them, they still can’t get away from the fact that ratings from Standard & Poor’s, Moody’s Investors Service, and, to a lesser extent, Fitch Ratings are embedded in the financial system’s DNA.

Widely used investment benchmarks depend on them, as do banks, mutual funds and pension funds, to name a few. Even the Federal Reserve is beholden to them.

The Fed’s great hope for jump-starting consumer and commercial real estate lending — the Term Asset-Backed Securities Loan Facility — uses ratings from the Big Three and two others as part of its criteria to determine which collateral investors can hand over to secure a loan.

That’s what gave the S&P about-face a big part of its bite. When S&P downgraded them a week ago, it disqualified the bonds from being used as collateral for loans under the Federal Reserve’s TALF program.

Their restored AAA status, of course, puts them back on the docket and increases their worth substantially. For those who sold them after the downgrade, the reversal is infuriating and unfair.

File this under “what took so long?”

Looks like at least one heavyweight pension fund, Calpers, is taking the much maligned ratings firms Moody’s Investors Service, Standard & Poor’s and Fitch to court for their role in making investors feel warm and fuzzy about complex financial instruments that it turns out no one really understood.

New York Times reports that Calpers is blaming about $1 billion in losses on “wildly inaccurate” ratings applied to securities that included those backed by subprime mortgages.

This about sums it up:

The AAA ratings given by the agencies “proved to be wildly inaccurate and unreasonably high,” according to the suit, which also said that the methods used by the rating agencies to assess these packages of securities “were seriously flawed in conception and incompetently applied.”

The SEC has tapped a team of examiners to monitor the agencies and will also take a look at the rating agencies business model, which has come under fire since the debt issuers, not investors, pay the firms for their services.  But for those who lost billions on these toxic securities, this is likely to be viewed as too little, too late.