The Malfeasance Column

Does the marketplace take Standard & Poor’s seriously?

John Rekenthaler 31.07.2013
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Puffery Piece
As you may have heard, the United States Department of Justice (DOJ) has brought a civil suit against Standard & Poor's (although curiously, not the company's fellow duopolist, Moody's) for inflating the ratings of various fixed-income securities from 2004 through 2007. The DOJ states that S&P engaged in a "scheme to defraud investors" by assigning overly generous ratings. According to the logic, S&P's leniency helped the newly issued securities to sell in the marketplace, and it encouraged those who issued them to return to S&P for additional business. The lawsuit notes that S&P could receive up to US$150,000 in fines for each residential mortgage-backed security that it rated, and several times more for each collateralized debt obligation.

Standard & Poor's has mounted several defenses, the newest and most notable being the puffery defense. The puffery defense asserts that a company's marketing claims are so over-the-top that nobody could seriously believe them to be true, and thus the company should not beheld liable for telling a lie. Examples would be a company marketing the "world's finest" pizza, or hawking its "everyday low prices." Last week, the company argued that it used puffery when it stated that its ratings were independent and objective.

Wait... what? It's one thing to shrug off vague advertising boasts of superiority as being puffery; it's quite another to claim that that very heart of a business enterprise rests on a harmless lie. The existence of Standard & Poor's depends upon its position of independence and objectivity. If Standard & Poor's were beholden to bond issuers, and gave ratings not upon the facts of the case but instead on which client paid it the most, or which figured to bring in the most future business, or other such business criteria, then its ratings would be powerless.

And the ratings are not powerless. Institutional bond investors use credit ratings. For one, their funds tend to be limited by prospectus (or charter) to a given credit range; for example, 80% of a portfolio's securities required to be rated BBB or better. Thus, even if investment managers thought that official bond ratings were nonsense, the marketplace would need them anyway. But more fundamentally, institutional investors don't believe that the ratings are nonsense. Yes, they usually state otherwise. Mention credit ratings and fund managers will wave their hands in amusement. "We don't look at the ratings. We do our own analysis."

Now that is true puffery. Few investment managers, if any, have enough research horsepower to conduct credit analysis on all the securities held by all its funds. Of course institutional investors supplement their own credit research by looking at the credit agencies' work (and also at the information implied by a security's market price). It's savvy marketing for a fund manager to claim otherwise, because if a manager doesn't know more than a credit agency, then why pay fees for the fund's service? Besides, admitting to paying attention to a credit agency isn't fashionable. However, official credit ratings certainly do influence the market.

I won't defend S&P's objectivity in the case at hand. Nor am I a fan of the company's pay-to-play model, by which the issuers pay the rating agency. That said, over most of its history, in most markets, at most times, S&P has been reasonably independent and objective. In addition, the ratings have been sufficiently accurate that the company has remained in business and its products have remained in demand.

The marketplace does take S&P's claim seriously. The court should not.

False Precision
Besides the credit agencies, another 2008 malefactor was the big banks. That year, many banks badly underestimated how far their investment holdings could decline in price. This misstep put them into danger at best--bankruptcy at worst--and destabilized the financial system to the cost of all.

Since then, efforts have been made to improve the calculation of the banks' key risk statistic, their "Value at Risk" calculation. The VAR has the attraction of being a very specific figure, as it is presented as the percentage chance of losing a certain dollar amount. For example, a bank might show a one-day VAR of US$220 million, at 99% probability. This statistic is interpreted as meaning there is a 99% chance that the bank will lose less than US$ 220 million on its portfolio in a given day, and a 1% chance that it will lose US$ 220 million or more. Regulators are now attempting to standardize their calculations to improve comparability.

But this misses the core issue. The real problem with VAR is that there is not a 1% probability that the bank will lose US$ 220 million or more. There is only a 1% probability if future financial markets behave as past markets have behaved. Since the markets surely will not be so obedient, then the true probability is either less or more than 1%, perhaps much less or--worse from the viewpoint of risk management--much more. So, despite the work of the past five years, the central problem remains: The uncertainty of the accuracy of the VAR estimate has not been resolved.

If You Call, Will They Come?
The final item in the troika of 2008 villains is the hedge fund--which, for the first time in 80 years, is being permitted to offer advertisements that can be seen by Mom and Pop in the U.S. As an unregistered share offering, hedge funds previously had faced strict advertising restrictions in the U.S. as per the Securities Act of 1933. They were only permitted to solicit wealthier,accredited investors--which meant in practice, that they couldn't advertise broadly at all, because there was no way of limiting the viewing audience to only the accredited. Earlier this month, the SEC lifted that ban.

I am fine with that. To start, although small investors in the U.S. can now see hedge-fund advertisements, they still are not permitted to buy hedge funds. Also, I doubt that they would buy even if they could. U.S. fund investors have grown accustomed to the benefits of low costs and transparency. ETFs are the wave of the future for the retail buyers; hedge funds are the past that never happened.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.



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John Rekenthaler  is vice president of research for Morningstar.

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