Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [61]
This tactic has mainly been successful because the rating agencies act as a cartel, leveraging their joint power to have fees magically converge and have ratings so similar that they have each participated in overrating AAA structured products backed by dodgy loans in 2007 that took substantial principal losses. Meanwhile, many market professionals, including me, pointed out in print that the AAA ratings were meaningless. The rating agencies presented a fairly united front in defending their methods (except for Fitch, which also participated in overrated CDOs and later seemed more responsive in downgrading structured products).
Furthermore, many investors have charters that require them to only buy products that have been rated by one or more of the top three rating agencies: Moody’s Corporation (Warren’s Berkshire Hathaway is a large minority investor); Standard & Poor’s (S&P), part of McGraw-Hill Cos., Inc.; and Fitch, owned by France-based Fimalac SA. “Ma and Pa” retail investors found that AAA product ended up in their pension funds and mutual funds because their money managers gave too much credence to an AAA rating.
Of the three rating agencies, Fitch has the smallest market share, but it has unique style. Fimalac’s chairman, Marc Ladreit de Lacharriere, and Veronique Morali, the chief operating officer, obeyed French disclosure requirements when she was paid a bonus of 8.7 million euros (around $9.94 million at the time) without board or compensation committee approval. According to the Financial Times, when the bonus was discovered in June 2003, the couple lived together, Fimalac’s finances were tight, and Mr. de Lacharriere had pledged 40 percent of his Fimalac shares as collateral to banks. Upon learning the news, a Fimalac director was more than a little concerned: “I said to myself, ‘Oh no, not this.’ . . . In the U.S. or UK, this would be very serious indeed.”3 “From a legal point of view,” said Ladreit de Lacharriere, “we have been meticulously correct.”4 In contrast,Warren Buffett suggested to his All-Stars that they should “start with what is legal, but always go on to what we would feel comfortable about being printed on the front page of our local paper.”5 I have to admit, though, French perfume on the “odor of impropriety”6 makes for entertaining reading.
Most of the market is dominated by Moody’s and Standard & Poor’s, especially the U.S. market, where these two U.S.-based rating agencies have been entrenched and have most of the historical data.
Moody’s awards a rating based on its estimate of expected loss, a single piece of information, and assigns a rating based on the safest (least expected loss) to the riskiest (highest expected loss): Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C. Anything above Baa3 is considered investment grade, and anything below that is considered speculative grade. Standard & Poor’s awards ratings based on default probabilities and label products AAA, AA+, AA, AA-, and so on. Fitch uses the same labels. As with Moody’s, anything above BBB- is considered investment grade and anything below is considered speculative grade. I’ll use AAA to denote the highest rating, but will specifically name Moody’s (which uses the Aaa notation) when I am making a point specific to them.
Since many money managers cannot buy bonds that are not rated investment grade, and since some are required to sell bonds that fall below investment grade, ratings have a huge impact. This is why when Moody’s admitted that impairment rates show no difference in performance between CDO tranches with a junk rating of BB- and an investment grade rating of BBB, it should have been headline financial news. It was not.7 Moody’s, Standard and Poor’s, and Fitch have an NRSRO designation, meaning they are “Nationally