Credit Rating Moats Keep Shrinking

The Wall Street Journal has reported that certain debt issuers, including Heineken N.V. and Credit Suisse Group, have been able to sell bonds without obtaining traditional credit ratings on the securities:

While small in scope so far, the deals indicate that credit ratings from major firms like Moody’s Investors Service and Standard & Poor’s aren’t a necessary ingredient for successful bond sales. The raters’ alphabetical risk assessments have been ubiquitous in credit markets for decades. And, even though policy makers and regulators criticized the ratings firms for failing to foresee risks in the markets that led to trillions in losses, they have yet to propose a viable alternative to the current system.

The prospect of security issuance without traditional credit ratings again calls into question the viability of the long established moats that have provided protection for franchises such as Moody’s and Standard and Poor’s for decades.  Moody’s moat has been clearly impaired not only by high profile errors in judgment over the past two years but also due to allegations of misconduct within the firm.

While it is true that the vast majority of new issues are still rated, any trend that appears to support the idea of unrated securities could lead to momentum as the practice becomes more acceptable.  At the very least, investors should begin to take more responsibility for due diligence regardless of the presence of a rating on a security under consideration.  Unfortunately, the presence of a rating on a bond has often caused investors to abdicate responsibility for conducting due diligence.  That is always a mistake.

While credit rating firms will continue to exist and the vast majority of securities will continue to be rated, it is difficult to argue that the longstanding economic moats enjoyed by these firms have not been irreparably harmed by the events of the past two years.

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