Why You Should Be Cautious About Credit Ratings

AAA credit ratings aren’t always what they seem

by Bob Stokes
Updated: January 17, 2017

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[Editor's Note: The text version of the story is below.]

Many people base their investment decisions on what they learn from credit rating agencies.

But here's a reminder of why doing so might be perilous to your portfolio (Bloomberg, Jan. 13):

Moody’s Corp. agreed to pay almost $864 million to resolve a multiyear U.S. investigation into credit ratings on subprime mortgage securities … .

Moody’s reached the agreement with the U.S. Justice Department and 21 states, which accused the company of inflating ratings on mortgage securities that were at the center of the 2008 financial crisis, the Justice Department said Jan. 13.

As you probably know, subprime loans go to borrowers with the weakest credit. Yet, as the article notes, in some instances, bonds backed by those mortgages received top-notch AAA credit ratings.

But why would credit rating agencies do such a thing? Bloomberg says:

Investigators in Congress found after the crash that in some cases, credit rating firms were giving out top grades to junk deals simply to win business from the banks preparing the securities.

The Financial Crisis Inquiry Commission says $11 trillion in U.S. household wealth was lost due to the 2007-2009 mortgage meltdown.

 You might think that "inflating ratings" is rare. But it's also happened at other times.

For example, back in 2001, Enron's bonds had an "investment grade" rating just four days before the company went bankrupt. Going back further, Olympia & York of Canada, which was the largest real estate developer in the world, had an AA rating in 1991. Just a year later, it was bankrupt. Rating agencies also missed the 1995 collapse of Barings, which was Britain's oldest merchant bank.

The same scenario applies to nations. This is from our January 2002 Elliott Wave Financial Forecast:

Argentina’s credit rating was downgraded in July [2001] after three years of recession and a 65% decline in its main stock index. Japan’s was reduced in December [2001] after a 72% decline over more than 10 years.

Robert Prechter's Conquer the Crash (2002) provided this warning years before the subprime mortgage crisis:

The most widely utilized rating services are almost always woefully late in warning you of problems within financial institutions. … When all you can see is dust, they just skip the downgrading process and shift the company's rating from "investment grade" to "default" status.

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