The World's Most Important Bond Investor Calls Ratings Agencies As Flawed

Bill Gross, the head investment officer of bond giant PIMCO and the most famous fixed-income investor in the world, dismissed Moody’s (NYSE: MCO) and S&P as deeply flawed arbiters of investment risk. In his monthly letter he said “Such services, however, while necessary in the ongoing scheme of financial regulation, are overpriced as well as subject to the influence of the issuer, which in turn muddles their minds and clouds their judgment to say the least.”

His beliefs have nothing to do with the outcome of investigations of the two firms.

Gross makes the obvious point that his firm is large enough to do its own research, making the ratings firms’ work  irrelevant to him, but he believes that they offer “second grade” intelligence to their clients.

Gross’ examination of the two ratings agencies goes well beyond the debacle of the mortgage-backed securities mess. Both companies gave derivatives that turned out to be junk “AAA” ratings. Congressional investigations and suits by state attorneys general claim that rich fees and shoddy research helped cause the credit crisis.

As Gross looks at Moody’s and S & P, his current concern is their ratings of sovereign debt. Spain, he reasons, does not deserve a high rating largely because of its 20% unemployment rate. There were rumors this week that the IMF was working with Spain on a 280 billion euro bailout which would be twice the size of the one prepared by the Eurozone for Greece.

The effectiveness of the rating system as they release their opinions on the weakest European nations will only face a real test when the deep trouble in the region is largely past or when it has erupted into one of the great financial disasters of recent years. If the road leads to disaster, Moody’s and S&P will be accused of being too optimistic about their ratings of Spain, Portugal, and Italy. The two firms will almost certainly say that they could not reasonably see the risk of  “contagion.” That is likely true, and lower ratings could  actually be the cause of a liquidity crisis in the region.

S&P and Moody’s are not in business to prevent contagion, no matter how convenient it is to take that point of view.  Nonetheless, their credit ratings of the weak European nations are almost certainly much too high.

Douglas A. McIntyre