Three major and 6 smaller credit rating agencies are registered with the SEC as Nationally Recognized Statistical Rating Organizations (“NRSROs”); these entities currently rate bonds upon their initial offering into the capital markets and often continue monitoring the rated securities’ health until their final maturity. Each rating category in each sector conveys specific ranges of probability of default. The three major agencies are Moody’s Investors Services (formerly a subsidiary of Dun & Bradstreet, now publicly owned), Standard & Poors (a subsidiary of McGraw-Hill) and Fitch Ratings (a subsidiary of Fimalac, a French credit rating and risk management firm).  A.M. Best Co. is a more specialized firm which rates the claims paying ability and as well as bonds of insurance companies, including all types of health insurance companies.

Individual and institutional investors – many of which are acting as fiduciaries -- rely on NRSROs to gauge the credit quality of their portfolios. Many institutional investors are required by their charters or other legal frameworks to maintain a specified minimum rating quality in given portfolios and must sell NRSRO-rated securities which have been down-graded and no longer meet the minimum standard. So these investors must take so-called “downgrade-risk” as well as default risk into account, as they build and maintain their portfolios.  Various credit insurance products have been developed to help investors mitigate both forms of risk. These include bond insurance offered by “monoline” financial guaranty insurance companies (e.g. MBIA, Ambac, et al) and Credit Default Swaps (CDS) offered by a wide range of market participants.

The current credit crisis is attributable in part to the failures of the 3 leading bond rating agencies to correctly model the risks of residential mortgage-backed securities (RMBSs) secured by pools of new types of sub-prime and other mortgage-linked loans, or to factor in the rising levels of fraud and other legal but extremely risky practices – e.g. loans requiring no documentation of current income -- in the mortgage industry. For example, some RMBS transactions used pools including many “no-doc” loans which were nonetheless categorized as “Prime” or the middle category “Alt-A”, because the borrowers had FICO scores consistent with Prime or Alt-A credit quality. However, FICO is really only a backward-looking measure of the borrower’s ability and willingness to pay; without verifiable current income data, the lenders and credit rating agencies were essentially blinding themselves to borrowers’ current and probable future ability to pay.   These failures were compounded by failures to accurately model complex “Collateralized Debt Obligations” (“CDOs”) which are bonds issued using pools of other bonds including RMBS, as their collateral, and the even more complex “CDO-squared” bonds which are bonds issued using pools of other CDOs.

Some observers argue that bond rating agencies such as the big 3 and others which are paid largely by the issuers of bonds will be inherently biased in favor of the issuers. Credit rating agencies heavily dependent on issuer-paid fees are perhaps most vulnerable to accusations of bias toward the issuers on the rating relationship’s back-end: the surveillance and updated rating of securities as they mature.  Some believe that the agencies don’t want to raise their clients’ hackles by probing the quality of previously closed transactions too closely and potentially downgrading them as swiftly as they should be, for fear of jeopardizing the overall business relationship.  Typically, the NRSROs have often seemed to regard the surveillance and updating function as less important than the original issuance rating function, so they have typically assigned junior staff in too small numbers and too few skills to rigorously perform this role. This helps explain why rating agencies so often are substantially behind the broader credit markets in reaching and publishing their credit judgment of securities which are trading among investors. Those rating agencies paid largely or solely by investors, e.g. Egan Jones Rating Company argue that only they can always be relied upon to provide a truly independent view of a given bond’s or other financial product’s credit quality.

Health providers of significant size, e.g. hospitals and hospital systems, almost always have their bond issues rated by one or more major NRSROs in order to have access to the nation’s tax-exempt or taxable bond markets.  Issuers of asset-backed bonds backed by pools of healthcare receivables, consumer credit card receivables, etc. also have used major NRSROs to rate their securities. Health Insurance Companies, including HMOs typically seek A.M. Best ratings of their claims paying ability, and of their bond issues.  As yet, there don’t appear to have been significant systemic failures by these rating agencies in their statistically-based risk modeling for issues in these healthcare sectors, no matter how they are compensated.

However, in particular cases, e.g. Allegheny Healthcare System, and Towers Financial, where fraud is a major factor in a credit’s deterioration, their ratings have proven to be grievously wrong.  Over the long course of formal, statistically bases credit evaluation, fraud has proven notoriously hard to detect, whatever the sector.

The assumptions underlying the typical independent credit rating agency business model include:

• Independent credit ratings – for all their historic shortcomings – will always be need in order for newly issued bonds and seasoned bonds to be priced rationally in primary and secondary bond markets. (Probably true.)
• The independence and rigor of initial and on-going credit rating judgments will not be influenced by the source of fees for initial and subsequent rating analysis. (Questonable.)
• The surveillance and up-dating function can continue to be given short shrift without undermining the value of the conventional rating agency franchise. (False.)