The Ratings Game

Think back to this time last year. Did you know what a subprime mortgage was?

The turmoil in the mortgage market during 2007 has given all of us an education on credit-market terminology. From mortgage-backed securities to collaterialized debt obligations and structured investment vehicles, all sorts of previously esoteric jargon has entered mainstream financial discussions.

Yet for all of these securities, analysts at ratings services like Moody's, Fitch Ratings, and McGraw-Hill's Standard and Poor's were doing due diligence to assess their creditworthiness. Unfortunately, in some cases, securities' ratings didn't reflect their actual risk. To figure out why this happened, you first have to understand how these ratings work.

Bond rating basics
The companies that rate bonds look at several factors in rating fixed-income securities. They look at the issuer's ability to make interest and principal payments to bondholders. They examine the provisions of a particular security and how they affect bondholders. Finally, they look at whether bondholders would get paid if the issuer declares bankruptcy, and if so, how much of their money bondholders would get back.

The highest ratings are AAA at S&P and Aaa at Moody's, corresponding to the minimum credit risk available. Bonds rated AA/Aa, A, or BBB/Baa are considered investment grade, while those rated BB/Ba or below fall into the category of junk bonds. Here are some samples of company bond ratings:

What went wrong?
The biggest controversy over bond ratings was how risky CDOs could get top AAA ratings. Ratings that appropriately reflected these risks could have prevented problems like those that caused Bear Stearns (NYSE:BSC) to close two of its hedge funds.

However, what investors discovered is that with more complex securities, ratings often only reflect relative levels of risk. Theoretically, it's easy to take a single loan and create safer and riskier securities from that loan. For instance, one bond might give investors the right to the first $100,000 in principal that a particular borrower repays on a $150,000 loan, while another bond would give investors the right to any additional principal repayments. You can see that the first bond would be safer -- it might get paid in full before owners of the second bond would get anything, so ratings services might rate the first bond AAA. Yet if it turns out that borrowers can't repay anything, then even the AAA bond will default.

In addition, some less creditworthy issuers got AAA ratings for their securities by offering default insurance from firms like MBIA (NYSE:MBI) and Ambac Financial (NYSE:ABK). If the issuer defaults, then the insurer is supposed to cover the payments. Yet with concerns that some insurers may not have enough capital to pay their obligations if a huge number of bonds default, bond investors are realizing there aren't any guarantees.

What to do
All this has taught bond investors a valuable lesson: Don't rely solely on others to do your research for you. While many take that advice to heart with stocks, it's tempting to ignore it with bonds, which are supposed to be safer than stocks. But the consequences of a misstep in the bond market can be just as devastating, and even more unexpected.

If you own individual bonds, take a fresh look at the companies that issued them. Also, if you own bonds through mutual funds, find out how fund managers are reacting to the credit crunch and what potential problems they've identified in their portfolios. Finding answers you don't like may be your cue to sell and find another investment.

Check out these articles to learn more about bonds and the credit crunch:

• How to Profit From This Incredible Fiasco
• Investing for the Worst-Case Scenario
• The Subprime Soap Opera Continues

For more basics about bonds, visit our Bond Center.