← Money Lessons with Andrew Temte, PhD, CFA
Money Lessons with Andrew Temte, PhD, CFA
The Dark Side of Credit Ratings: Three Failures Every Investor Should Know
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Foreign. Hi, I'm Andy Tempte and welcome to Money Lessons. Join me every Saturday morning for bite sized lessons that are designed to improve financial literacy around the world. Today is February 14, 2026. Happy Valentine's Day. Last week we explored credit ratings, the letter grade system that John Moody pioneered in 1909 that transformed how invest investors evaluate bond risk. We discovered how the big three agencies assign ratings, what factors drive those assessments, and how historical default rates validate the system's usefulness. But here is an uncomfortable truth. Credit ratings have failed spectacularly at critical moments in time. And today we're examining three episodes where the rating system broke down and what regulators did to address those failures. You see, I almost said examinating, just like I did last week. So here we go. On June 21, 1970, Penn Central Railroad filed for bankruptcy, the largest corporate failure in American history. At that time, the company controlled over 20,000 miles of track and was the sixth largest corporation in America. Here's what shocked rating agencies had maintained investment grade ratings on Penn Central's debt right up until the bankruptcy filing. The company had roughly $200 million in commercial paper outstanding, which are short term IOUs that corporations use for everyday financing. Investors who trusted those ratings lost heavily. The Penn Central collapse exposed a troubling gap between ratings and reality. How could agencies miss warning signs at one of America's largest corporations? The failure raised fundamental questions about the depth and rigor of credit analysis. Now, around this same time, rating agencies faced a separate business challenge. The photocopying technology that had become widespread was creating a free rider problem. Investors could simply copy rating publications instead of purchasing them, undermining agency revenues under the user pay model. In October of 1970, Moody's switched to an issuer pays model where the companies being rated pay for the service. Standard and Poor's followed in 1974. This solved the revenue problem, but created a new concern that would prove more damaging in later decades. When issuers pay for their own ratings, might agencies feel pressure to deliver favorable assessments? The answer is yes, there is a conflict of interest. So let's Fast forward to 2001. The Enron Corporation had grown into an energy trading giant with $63.4 billion in assets. The company's stock peaked at nearly $90 a share in the summer of 2000 and rating agencies maintained solid investment grade ratings on its debt. But warning signs were accumulating. In March of 2001, Fortune magazine published Is Enron Overpriced? An article noting that analysts couldn't explain how the company actually made money. By August of 2001, CEO Jeffrey Skilling abruptly resigned and the stock had fallen to $42 a share. On October 16, Enron reported a 618 million doll quarterly loss. Six days later, the SEC announced a formal investigation and the stock plunged further to $20 a share. Here's the troubling part. Even as Enron's stock collapsed from $20 to under a dollar over the following weeks, rating agencies kept the company at investment grade. Moody's didn't downgrade Enron to junk status until November 28, 2001, days before the company filed for bankruptcy on December 2. Thousands of employees lost retirement savings. Bondholders who trusted investment grade ratings suffered devastating losses. The agencies defended themselves by arguing that Enron's executives had provided misleading information. But critics countered that independent analysis should have uncovered the red flags. Enron revealed that ratings often lag rather than lead. By the time downgrades arrive, the damage may already be done. Now let's Fast forward to 2008. The most devastating rating failure came during the 2008 financial crisis. This time the problem wasn't individual corporate ratings. It was the ratings assigned to mortgage backed. Now we're going to talk about mortgage backed securities here without really defining what they are. We will get to mortgage backed securities and other structured products in later episodes. For now, between 2000 and 2007, Moody's alone rated nearly 45,000 mortgage related securities. More than half of them received AAA ratings, the highest possible grade supposedly indic indicating minimal default risk. The numbers that followed were staggering. Between autumn of 2007 and mid 2008, rating agencies downgraded nearly $2 trillion in mortgage backed securities. By the end of 2008, roughly 80% of the securities that had carried AAA ratings were downgraded to junk. Banks worldwide recorded over half a trillion DOL losses tied to these instruments. So what went wrong? The agencies had applied models built on historical data that didn't account for a nationwide housing collapse. They'd also faced intense competitive pressure. If one agency wouldn't deliver favorable ratings on complex mortgage products, issuers could shop for better treatment elsewhere. This is that conflict embedded in the issuer's pay model, which seemed manageable for traditional corporate bonds, but proved toxic when combined with complex structured products and aggressive Wall street deal making. Now, Congress responded with the Dodd Frank Wall Street Reform act, which was signed into law on July 21st of 2010. The legislation created an office ratings within the SEC to oversee rating agencies. It required annual examinations with public reporting of findings and increased agencies legal liability for inaccurate ratings. The Dodd Frank act also directed regulators to remove credit rating requirements from federal rules, an acknowledgment that over reliance on ratings had contributed to the crisis. Now, research on Dodd Frank's impact in the subsequent years shows mixed results. Post reform, ratings became somewhat more conservative, but studies suggest that markets now place less weight on rating changes than before. The fundamental issuer pays model remains in place, and the Big Three agencies continue to dominate the market. So what's the lesson? Credit ratings remain useful tools. Historical default rates confirm that higher rated bonds default less frequently than lower rated bonds. But Penn Central, Enron and the 2008 crisis teach us that ratings have limitations. They reflect opinions based on available information, not guarantees. They can lag determine deteriorating market conditions. And the business model that sustains rating agencies creates inherent tensions that sophisticated investors must understand. So we should use ratings as one input among many, never as a substitute for your own judgment about risk. Until next week, I wish you grace, dignity and compassion. My name is Andy Tempte, and this is Money Lessons. You can find the show on all the major streaming services as well as out on YouTube. Please like, subscribe, rate and most importantly, share this public good with a neighbor, a family member, a friend or a colleague if you like them. The show was produced by Nick Tempte, and we'll see you next week on Money Lessons.