Former head of S&P structured finance: Ratings aren't meaningful or trusted

As reported by Bloomberg, the bottom line on credit ratings from David Jacob, the former head of structured finance at S&P is

“[Rating companies are] there because people have to have them, not because people believe in them,” ....  “Maybe retail investors do, that’s the unfortunate part, but I think institutional investors don’t.”... 

Jacob, hired four years ago to help restore confidence in S&P, says policy makers haven’t gone far enough to reduce reliance on the ratings companies, granted the authority by U.S. regulators 76 years ago to determine which borrowers deserve credit.....

“Ratings are not God’s holy work,” said Jacob, 56, a graduate of Queens College in New York with degrees in math and finance from New York University. “It’s a business. It’s a fine balance between trying to get a certain amount of market share versus losing your credibility.”...

It is a business that would change considerably if more transparency were brought into all the opaque corners of the financial markets.

With everyone having access to the same information, the rating firms would have to show they add value through their analysis.

“Moody’s is not going to detect some problem in advance and move a rating to warn the public,” said Fisher, whose firm manages about $44 billion. “Whether it’s a stock or a bond, the free market already did that. Moody’s goes along afterwards and effectively validates what the market’s already done.”... 

 The clear perception is that the rating companies are a lagging indicator at best.

S&P President Douglas Peterson said at a meeting of the Institute of International Finance in Copenhagen on June 6 that ratings companies help ensure that bond issuers provide “transparent information” under “strict standards of governance and control.”... 

Transparent information to whom?

Historically the rating companies model has been built not on public disclosures by the borrowers, but rather that the rating firms have access to information that is unavailable to other market participants.

Jacob joined S&P after managing commercial- and residential-mortgage bond groups at Nomura Holdings Inc. from 1993 to 2007. He said he sought to ensure that S&P analysts didn’t loosen standards at the request of bankers. The firm won less business in certain areas as a result. 

“We’ve swung back from where it was before when it felt more like the Wild West, but of course it puts a crimp on the business,” Jacob said in the interview last month. “It’s important for investors to watch to see if there’s a change and a shift in terms of trying to rebuild that market share.”....

The path to rebuilding market share is by loosening rating standards.  We saw how well that worked in structured finance leading up to the financial crisis.

Grading government bonds is outside ratings companies’ traditional areas of expertise, Jacob said. 

“You’re talking about politicians, you’re talking about legislators, you’re not talking about credit risk,” he said. “I don’t see how a rating agency has any better call on it than you or me or anybody else.”... 

Jacob said he is now considering working in financial regulation. 

One reform that would improve the quality of ratings would be to have all scores correspond to percentage chances of default, rather than the vague definitions now in use. S&P says its top rating means the issuer is “extremely strong,” while Aaa bonds are considered “highest quality” at Moody’s. 

“I was there three and a half years and I still don’t understand it,” Jacob said. “When people can use the same set of letters and mean entirely different things, then they become useless.”

Bottom line:  rating companies are another layer of opacity in the financial system.