Commentary: Investment rating services deserve an 'F'

Daily Record (Rochester, NY), Sep 24, 2008 by George W Karpus

Many investment committees write guidelines to permit money managers or institutions to buy investments based on ratings provided by companies such as Moody's, Standard and Poor's and Fitch.

I want to point out some powerful examples that prove the rating agencies have been incompetent for years.

The 158-year-old firm of Lehman Brothers went bankrupt just last week. Its bonds and commercial paper were rated investment grade as of just last week. Several money market funds that relied on our nationally recognized rating services have lost a lot of money with Lehman's bankruptcy, causing investors to lose money.

AIG, one of the largest insurance companies in the world, might have had to file for bankruptcy had it not been for a government bailout loan. Its commercial paper and bonds also were rated investment grade until very recently.

Earlier this year, Charles Schwab had a money market mutual fund through which investors experienced severe losses due, in part, to the ineptness of our nationally recognized rating services.

Consider a simple question: Can you imagine why mortgage pools, in which a homeowner puts 20 percent down and borrows 80 percent against a house (four times debt to equity) would receive a AAA- rating?

Keep in mind that, in 32 states, it takes a mortgagor more than a year to foreclose on his collateral. Common sense suggests you should rate those mortgages lower investment grade, at best, and sub- prime mortgages should be rated in a non-investment grade or junk category. But that is not the case with our nationally-recognized rating agencies, which were giving many such pools AAA ratings. Many of the problems occurring today have been and continue to be caused by the rating services.

Overall, my nearly 40 years of experience has taught me not to trust the rating services. Experience also has taught me to be safe, not sorry. Here are all of the reasons why I believe you should not trust our nationally recognized rating services:

* Issuers pay the rating services to be rated;

* Generally, a security is not re-rated unless there is a new financing of that security;

* Rating services are slow to react; and

* Ratings are not absolute, and are only relative to that class of securities.

It should be noted, however that my last point is about to change. The rating services recently announced they are moving to an absolute system during the next several months.

What does that mean for investors moving forward? Generally, if a BBB municipal bond has a long-term default rate of .62, whereas a AAA corporate bond has a long-term default rate of .60, I believe municipals will be upgraded substantially, corporates will be downgraded and most mortgage pools, unless backed by the government or government agencies, will be rated lower investment grade or non- investment grade.

Because my firm didn't buy the mortgage pools so often rated AAA, we have performed well for our clients. Many banks and investment banks, however, did not see the problems. Avoiding non-government backed mortgage related securities and moving our clients into government-only money market mutual funds, while avoiding debt obligations trading cheap in the marketplace relative to their credit ratings, contributed to our success.

Looking forward, overweighting municipal securities for individuals and using municipals in taxable accounts should produce excellent future returns because of their high yields relative to taxables, potential upgrades from the rating services and prospects for a tax increase. The best way to participate in such securities is through closed-end municipal bond funds, currently selling at wide discounts.

As an investor, don't be afraid to question what naturally doesn't seem right. In my opinion, the ratings agencies definitely deserve an "F" for their role in perpetuating the problems in the current economic environment.

George W. Karpus is president of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.