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On both sides of the Atlantic, politicians are calling for closer scrutiny. In the US, Barney Frank, Democrat chairman of the House financial services committee is planning hearings on credit rating agencies (CRAs), while European Union finance ministers are expected to discuss the agencies’ role in this summer’s financial upheaval when they gather in Oporto, Portugal, for an informal meeting, in mid-September.
Several respected academics have also weighted in, providing intellectual substance to the criticism. And, in the background is the implicit threat of further regulation.
The response of the agencies’ senior management has been a mixture of bewilderment and frustration. Their methods, they say, are entirely transparent, their models can be freely examined, and they have always made it clear that ratings are only an opinion of the likelihood of default, and should not be used as the sole basis of investment decisions
CRAs often receive a lot of flak when financial problems occur, as when they were wrong-footed during the emerging market crises of the 1990s. And again when Enron, the US energy giant, Worldcom, the telecommunications company, and several others collapsed at the beginning of this decade amid corporate governance scandals. In some cases, the agencies only downgraded these companies a few days before they actually defaulted. But, then, the defaults were often the result of fraud and improper accounting.
This time the situation is rather different. The focus is on one of the fastest growing areas of the capital markets – structured financial products – which also provides the leading rating agencies with a substantial, and rapidly increasing share of their revenues. It is not just a question of reputational competence, but about the role of the CRAs in this booming market, and the widely perceived conflicts of interest that they face.
French President Nicolas Sarkozy and France’s chief financial securities regulator Michel Prada have emerged as their leading critics in Europe. In a mid-August letter to German Chanceller Angela Merkel, chairwoman of the Group of Eight leading industrial nations, the French president called for a “careful examination” of the role that rating agencies play in “mapping risks.” And Michel Prada, head of the Autorité des Marchés Financiers (AMF), told the Financial Times newspaper that the potential conflicts of interest for the CRAs are similar to those that emerged in the audit profession when the leading accounting firms moved into consultancy. This move is regarded as ultimately one of the causes behind the Enron accounting scandal. “I do hope that it does not take another Enron for every one to look at the issue of rating agencies,” Prada is reported to have said.
Given the size and rapid growth of the securitisation market, it is not surprising that politicians and regulators are exhibiting concern over how well it functions and the role of the CRAs. In the US alone, there is reckoned to be almost $9,000 billion (Ԇ,600 billion) in outstanding structured securities – created by slicing, dicing and repackaging the risks and revenues attaching to existing pools of loans, bonds, mortgages, credit card and trade receivables, or even derivatives on such assets.
From this process emerge asset-backed securities such as collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS). Although rather smaller that the US asset-backed market, European securitisation leapt by 40% in 2006 to �� billion, according to a paper published by the French regulator, in March. Outstanding European issuance is estimated to have passed ԁ,000 billion ($1,363 billion). Underlining the correlation between the growth of the securitisation market and rating agency income, the AMF’s March paper also reckons that structured finance activity now accounts for between 40% and 50% of the revenue of the leading rating agencies – Moody’s Investor Services, Standard & Poor’s, and Fitch Ratings.
What the events of this summer have shown is that the prices of asset-backed securities (ABS) can be highly volatile. And, ABS can also be an uncomfortably effective channel for spreading the problems of one sector to other sectors. Thus, when problems developed in the US home mortgage market for less creditworthy borrowers (the sub-prime market), these were rapidly relayed to the banks and hedge funds that had invested in the CDOs and RMBS created from pools of sub-prime mortgages. Those investors that marked their portfolios to market levels were soon showing large losses.
Another transmission channel has been the so-called SIV-lites – structured investment vehicles, which are similar to CDOs, but fund themselves through the short-term asset-backed commercial paper market, rather than by long-term senior debt. Trouble at two of these vehicles quickly tainted the commercial paper market. Uncertainty about who was carrying the ultimate risk, led to the evaporation of liquidity for firms thought to be invested in many of these asset-backed products.
Against this background, critics of rating agencies make three broad charges. First, the traditional rating scale is not appropriate for structured products. A triple-A rating for a bond conveys a clear meaning. But a triple-A rating for a tranche of a CDO does not. Second, rating agencies have been slow to see the developing problems in the sub-prime market, and the subsequent spread to other sectors. And third, the close involvement of rating agencies in the structuring process means, in the words of one critic, that they are no longer referees on the playing field, but have actually become players.
One critic, professor Frank Partnoy, at the University of San Diego’s law school, and a former Wall Street banker, told the Financial Times: Rating agencies know certain investment funds and pension funds can only buy bonds if they get triple-A ratings. “They’re playing this game to create a triple-A with a juicier yield. They know how the law will treat that, but they also know its a different kind of triple-A,” he reportedly said. In a similar vein, another critic, Don Bownstein, chief executive of Structured Portfolio Management, a hedge fund, argued: “What people failed to understand is that, when it comes to ratings for structured finance, there is a very real difference from traditional corporate bond ratings. The problem is that investors were in such an advanced state of liquidity intoxication that they were easily convinced the ratings were the same.”
It's a line of attack that also gets support from Charles Calomiris, professor of financial institutions at Columbia University, and Joseph Mason, associate professor of finance at Drexel University. In a joint article, they argued that CRAs had been given a unique power to effectively act as regulators. This is because portfolio regulations for banks, insurance companies and pension funds set minimum ratings on the debts that these intermediaries are permitted to purchase. The agencies now effectively decide which securities are safe enough for regulated intermediaries to hold. This creates a “strong incentive for grade inflation,” and makes the meaning of ratings harder to discern, the professors wrote.
“Regulated investors encourage rating agencies to understate risk so that the menu of high-yielding securities available to them is larger. The regulatory use of ratings has thus changed the constituency demanding a rating from free-market investors interested in a conservative opinion to regulated investors looking for an inflated one,” according to the professors.
Rating agencies are robustly defending themselves against these charges. In late August, Standard & Poor’s published a paper aimed at clarifying “some of the misconceptions that surround the rating of structured finance securities.” Written by Ian Bell, head of European structured finance, and Joanne Rose, executive managing director for global structured finance ratings, in New York, the paper says: “The fact that the structured finance rating agency process involves a degree of interaction and that arrangers may change structures to meet rating agency criteria has led some commentators to muse whether the ratings analyst becomes an advisor. The answer is ‘no.’” In no way, the authors say, “does what occurs in the structured finance rating process ever amount to ‘advisory’ work. We will never tell an arranger what it should or should not do.” “We do not structure transactions,” adds S&P spokesman Martin Winn, “nor do we determine which deals can, or cannot, proceed. “Our ratings criteria are publicly available, and they are non-negotiable.”
A similar view comes from Nigel Phipps, senior credit officer for Europe, at Moody’s in London. “Our models and methodologies are on the website, and we are committed to that transparency. It is a crucial bit of the control,” he says, “because our ratings must be consisitent with the public methodology.”
CRAs have to gather sufficient good information about a structured deal to give it a rating. “If someone dreams up some complex instrument, does it make sense to stop rating agencies discussing it, or having any contact with the arranger to get clarifications?” asks Phipps rhetorically. “Should the agency just be restricted to the limited information in the public domain?”
Critics suggest that regular CRA contact with arrangers and investment bankers could lead rating analysts to “see thing’s the banker’s way” – the rating agency equivalent of “regulatory capture.”
Responding to this suggestion, in their S&P paper, Bell and Rose say: “We are intensely aware that our entire franchise rests on our reputation for independence and integrity. Therefore, giving in to ‘market capture’ would reduce the very value of the rating, and is not in the interest of the rating agency.”
But the fact that the rating agencies are paid by the issuer, rather than the investor adds to the suspicion that they could be vulnerable to undue influence. While accepting that this business model has potential conflicts of interest, Moody’s Phipps argues that “any model has potential conflicts. There is not a conflict-free model,” he says. There could be a conflict of interest if a rating agency was just about to downgrade a rated debt held by an investor, who also paid a fee to that agency. “We have structures in place to handle the obvious conflicts that can occur,” notes Phipps. “But under an investor-pays model, the ratings would no longer be public. They would be available only to investors who paid for them, and there would be the loss of a public good.”
Both S&P and Moody’s also claim to have given warnings as early as last year about the deterioration they saw in the sub-prime market, and taken action, including amending some factors in their methodologies. S&P’s Martin Winn says “we can only act on the basis of objective data and information, not speculation. We have to see how the mortgage pools backing the securities we rate are performing. And it takes time for this to become clear.”
The agency now has sufficient information to show that the sub-prime loans issued in 2005-2006 are experiencing loss trends above any historic precedent, and above S&P’s original rating assumptions, Winn admits. “While the market can follow its instinct, we have to act on the facts.” Winn says that, out of 14,000 sub-prime first mortgage securities rated by S&P, only 3 have defaulted since July 1. And, no triple-As among the securities have been downgraded.
And he rejects the suggestion that a triple-A rating for a structured product might be qualitatively different to a traditional triple-A for bonds. “In terms of default risk, we expect a triple-A rating to perform similarly across all asset classes,” Winn says. “They may have different market characteristics, but these are not addressed by ratings, which are simply an opinion about default risk.”
Singing from the same hymn sheet, Phipps says: “We rate to expected loss. We don’t rate to liquidity. There are many other elements in an investment that are important besides the rating, including the investor’s time horizon.”
Some critics observe that credit spreads on rated debt securities can vary considerably even when securities carry the same rating. This, they say, raises questions about the quality of ratings. Addressing this criticism, Bell and Rose argue in their S&P paper that there are numerous reasons why this can happen, not least the likely liquidity of particular securities – that is, how frequently they trade, and hence how easy they may be to sell in the secondary market.
These arguments are set to come under close scrutiny in coming months. In the US, where new regulations for the rating industry are still bedding down, Christopher Cox, chairman of the Securities and Exchange Commission, is promising to monitor closely the activities of these agencies. EU finance ministers have, so far, preferred to see CRAs adopt a self-regulatory approach. The agencies have agreed to abide by a Code of Conduct developed under the auspices of the Madrid-based International Organisation of Securities Commissions (IOSCO), an umbrella body for regulators from over 100 countries.
Compliance with this Code is monitored both by IOSCO, and the Committee of European Securities Regulators (CESR), which advices the European Commission on securities regulation. CESR has just embarked on its second annual review of compliance with the Code, and is focusing particularly on structured finance. It is currently consulting the rating agencies and interested third parties such as investors and trade associations, and is expected to report to internal markets Commissioner Charlie McCreevy in the spring next year.
McCreevy was due to meet EU securities supervisors as GRR went to press, amid growing calls for the European Commission to hold an open hearing into the role and practices of rating agencies. In a apeech to the European Parliament in September, which was highly critical off rating agencies, McCreevey said: “The role of credit agencies needs to be clearer. What they do. And what they don't. The extent to which they can be relied upon. The extent to which they can't. I am following up on these issues with CESR and I intend raising them also with our international partners.”
Meanwhile, IOSCO has separately decided to undertake its own enquiry in to the rating of structured product, to see whether changes are required in its Code of Conduct.
Despite this flurry of reviews and enquiries, European Commission staff insist that there is no presumption that direct regulation of rating agencies is necessary. The initial responses to CESR’s public questionnaire on structured product ratings do not suggest any clamour among investors for EU regulation of the ratings industry. Trade associations representing investors and other users of ratings, such as the Association of British Insurers and the European Securitisation Forum, say they are broadly satisfied with the way CRAs assess the risks of structured products, and provide that information to the market.
For their part, the rating agencies say they welcome the continuing dialogue with regulators because it provides an opportunity for them to achieve a better understanding of the role they play in the market, and their ratings process and track record. “We are not per se against regulation,” says Phipps. “Wide variation of standards - different record-keeping standards and the like - is the most difficult and expensive issue for us,” he reckons.
By Melvyn Westlake
Global Risk Regulator website