Rating agencies need to clean up their act as regulation looms, says Neil Hodge

While the role of the banks has been well documented in bringing about the current global credit crunch, the role of the industry that whetted the banks’ appetites to invest in high-risk debt vehicles had largely escaped censure – until now. This year, probes by regulators on both sides of the Atlantic have concluded that credit rating agencies need tougher regulation and that voluntary codes are no longer suitable.

Credit rating agencies gauge the credit-worthiness of organisations issuing debt instruments, such as corporate and government bonds, so that investors, banks, regulators and other market operators can use them to measure relative credit risk. Credit rating agencies are, therefore, crucial gatekeepers in the credit markets and play a vital role in promoting corporate governance: billions of dollars worth of debt is issued and borrowed based on their analysis. If a company is ‘downgraded’, investors either feel compelled to dump shares, or force the company to dump executives and change tack – quickly.

But as well as rating traditional bonds, credit rating agencies also offer advice on structured financial products, such as collateralised debt obligations (CDOs), complex portfolios of fixed-income assets that are divided into tranches, with each tranche containing assets holding a different level of credit risk. It is here that credit rating agencies became unstuck. CDOs skyrocketed in popularity prior to 2007, with sales of collateralised debt instruments reaching US$503bn in 2006 – five times higher than in 2004, according to investment bank Morgan Stanley. Unfortunately for investors, many CDOs included sub-prime mortgage bonds within their complex tranches – with catastrophic results.

Take one US$340.7m CDO issued by Credit Suisse Group in December 2000. Over four-fifths (85%) of the CDO’s tranches received the top AAA or Aaa rating by the big three credit rating agencies: Standard & Poor’s (S&P), Fitch Ratings and Moody’s Investors Service. Indeed, 95% of the CDO received an ‘investment grade’ rating. However, the other 5% of the CDO included far riskier sub-prime mortgage bonds. Defaults in sub-prime mortgages mounted over the six years following December 2000, contributing to a total loss of around US$125m for the Credit Suisse CDO by the end of 2006. That figure is now a drop in the bucket compared to what the banks have collectively declared they have lost.

Where they are going wrong

Attacks on rating agencies focus on two charges. The first criticism is that agencies receive fees from organisations issuing debt and constructing debt instruments such as CDOs, so they are being paid by the issuers whose securities they rate. This, critics argue, makes them unable to provide objective information about the risks associated with investing in these debt instruments.

The second bone of contention is that credit rating agencies’ methods of rating and categorising CDOs do not make it easy enough for investors to see the true levels of risks they carry. The triple-A ratings assigned by credit rating agencies would have led some investors to believe that these complex debt structures were bomb-proof, but as demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols.

Consequently, after having their fingers burnt, investors want more information about the ratings process and how ratings are assigned. ‘Our members have noted the inevitability of the tension between competition between credit rating agencies for new rating assignments and the common good of the investor base overall,’ says one institutional investor. ‘Disclosure and high standards of corporate governance are seen as the keys to managing this tension,’ it adds.

Another institutional investor has said that ‘credit rating agencies have become perhaps the only source of detailed information to the market, yet they may not owe investors a duty of care when rating or reporting on structured finance instruments. Our members are concerned that the structured finance market is developing in such a way that there is a lack of information they can rely on in the legal sense when making decisions.’

The industry has attempted to agree on some degree of voluntary reform to stave off regulation. The Securities Industry and Financial Markets Association (SIFMA) credit rating agency task force published its recommendations in July aimed at improving disclosure, transparency, reducing potential conflicts of interest, and revealing their fee structures (see box). However, it rejected out of hand one of the few practical suggestions that has received broader attention: the idea of changing the traditional ratings scale, or adding a suffix or identifier to structured finance ratings, which had been championed by Michel Prada, the head of the French financial regulator.

SIFMA said that it would lead to significant unnecessary costs – related to updating computer systems, investment mandates and state and national laws – while potentially triggering more forced sales of structured bonds by investment managers no longer mandated to hold them. In any case, it added, the changes would add little in terms of transparency, saying they would ‘at best be a cosmetic solution’.

&#8220Investors want more information about the ratings process and how ratings are assigned


Regulation looming?

While these attempts to improve service have been welcomed, investor concerns have prompted regulators to investigate the industry more closely, and regulation may not be too far behind. At the beginning of July the Securities and Exchange Commission (SEC), the US financial regulator, concluded that credit rating agencies failed to manage conflicts of interest in assigning top ratings to bonds backed by sub-prime mortgages and other assets. The findings of the SEC probe followed months of examinations that sought to determine whether the rating agencies diverged from their usual procedures to publish higher ratings for complex financial products tied to mortgages as the sector began to boom.

The conclusions were far from complimentary. ‘The public will see that there have been significant problems,’ said Christopher Cox, SEC chairman. ‘There have been instances in which there were people both pitching the business, debating the fees and also involved in the analytical side’, adding that credit raters were ‘deluged with requests’ for ratings and ‘the volume of work taxed the staffs in ways that caused them to cut corners’ and ‘to deviate from their models’.

Cox said the SEC’s explicit reference to ratings in its rules ‘may be contributing to an uncritical reliance on credit ratings as a substitute for independent evaluation’. The regulator is therefore recommending that explicit references to credit ratings be dropped or changed from most of its market rules. That means investors, including money market managers, would have to increasingly examine an asset’s liquidity, volatility and risk of losses using independent judgments – instead of credit ratings. Wall Street banks would also be affected, because they use ratings to help assess which assets can best meet the capital requirements imposed by regulators.

The proposed changes are part of a broad package of measures targeted at the credit rating industry and come as global regulators re-examine the degree to which their own regulatory frameworks have become dependent on credit ratings.

Cox said: ‘Several of our regulations implicitly assume that securities with high credit ratings are liquid and have lower price volatility. But since structured finance products can be very different from other rated instruments in these respects, there is good reason for us to examine the precise way that credit ratings are used in our rules.’ Paul Atkins, SEC commissioner, added more succinctly: ‘Blind reliance on ratings is not something the SEC should foster.’

Just one factor

Julia Graham, chair of the Association of Insurance and Risk Managers (AIRMIC) in the UK, agrees that people need to be more sceptical about the ratings that credit rating agencies assign. ‘People use ratings as a bible for gaining assurance. It is a classic case of investors relying on just one indicator in isolation and not even thinking of challenging the findings or asking what information these ratings are actually based on. Ratings are useful, but investors must not rely solely on their opinions and need to be more cautious about how these ratings are calculated.

‘Investors need to be more sceptical. However, it is not all their responsibility. Credit ratings agencies will also need to take measures to ensure that the processes involved in assigning these ratings are more transparent and that more information is disclosed so that conflicts of interest are removed between raising fee income and writing reports.’

Peter Montagnon, director of investment affairs at the Association of British Insurers (ABI), says credit rating agencies have taken too much of the blame and that investors also need to act more responsibly. ‘As large investors our members do not rely heavily on ratings, regarding them as only one factor in a decision to invest,’ he says.

But Montagnon adds that the ABI – and other institutional investors – prefer reform of how the ratings agencies work, rather than more regulation which could make it more difficult for them to perform. ‘We do not currently consider regulation is appropriate, as this might lead to standardisation and lack of choice, but the rating agencies’ involvement in structured finance has raised a series of particular problems,’ says Montagnon. ‘We would prefer these to be addressed through a robust code of best practice which addresses conflicts of interest and lack of transparency. This should be agreed at an international level. Regulation should follow only if it fails,’ he says.

&#8220The fundamental flaw is that the agencies are paid by issuers, not by investors


One director of risk management at a leading European firm, agrees that investors have a ‘blind reliance’ on credit ratings, ‘often because they do not necessarily have much other hard analytical data to go on regarding the credit-worthiness of their potential partners.’

‘Credit agencies have certainly got it wrong in the risk and insurance industry, but the fault probably lies with investors for interpreting credit opinions as gospel truth, rather than perhaps being a little more sceptical and seeking other assessments of financial security beyond credit ratings,’ he says. ‘I’m not sure that monitoring agencies is the best way forward, other than testing their independence when providing opinions. The most important thing, is to ensure that there is absolute transparency in the ratings provided.

EU stepping in

But it is not just the US that is eager to keep a better regulatory watch over the activities of the world’s largest credit rating agencies. Europe is also keen to devise strict rules – and quickly. On 8 July the European Union (EU) announced that it will take a first step towards stricter regulation of credit rating agencies by supporting calls to register them and make them answerable to financial market supervisors.

The main credit rating agencies must already register in the US under a requirement introduced last year that brings them under the supervision of the SEC. The European Commission is now looking to do something similar.

The agencies accept the case for registration in Europe, but they are concerned that the push for tighter EU regulation may result in different rules from those in the US and thus inconsistent treatment of their activities in the world’s big financial centres.

Deven Sharma, president of S&P, said in a statement: ‘We are committed to continuing working together with market participants and policymakers, including the European Commission, to find solutions that support the effective functioning of global capital markets. We share the same goal of improving the transparency of structured products and ratings, and believe the global market is best served by a consistent international approach.’

Since the industry has come under closer scrutiny, the big three agencies have all announced some degree of reform. Moody’s says that it is moving to re-examine the accuracy of all its computer models and place them under a centralised monitoring system after it formally acknowledged that a glitch had appeared in one mathematical model used to rate complex products, leading it to incorrectly award top notch triple-A ratings to about US$1bn of complex instruments. S&P has now created an internal committee to oversee how the agency uses complex computer models, while Fitch has also announced potential new rating scales and indicators for global structured finance.

S&P believes that any regulatory initiative in Europe should focus on the integrity and transparency of the rating process, and not seek to determine the content of ratings and methodologies, or become involved in reviewing individual ratings, as that would risk limiting market innovation, call into question the independence of ratings, and potentially create moral hazard as overseers may be perceived to endorse ratings opinions.

Charlie McCreevy, the EU’s internal market commissioner, who believes that the agencies’ system of voluntary self regulation has proved inadequate, plans to set out his proposals for registration, external oversight and corporate governance reform at credit rating agencies in October, with a view to getting them turned swiftly into law by EU governments and the European parliament. The commissioner has support from influential legislators in the European parliament, who are pressing for the Committee of European Securities Regulators (CESR), which groups the EU’s national supervisors, to be the body where the agencies will register.

McCreevy has previously drawn attention to conflicts of interest that he says are inherent in the agencies’ business model. Speaking at a conference in Dublin in June, McCreevy warned that he would not ‘wait indefinitely for the credit rating agencies to come forward with meaningful proposals to put their houses in order’, adding that the voluntary International Organisation of Securities Commissions’ code of conduct had been shown to be ‘a toothless wonder’ and that ‘no supervisor appears to have got as much as a sniff of the rot at the heart of the structured finance rating process before it all blew up’.

However, some EU officials acknowledge that registration of credit rating agencies is unlikely to provide solutions to all the problems. One EU spokesman said: ‘The fundamental flaw is that the agencies are paid by issuers, not by investors. No amount of regulation can fix that conflict of interest unless the model is totally changed.’

The way forward for reform

The Securities Industry and Financial Markets Association (SIFMA) credit rating agency task force published its recommendations in July to improve transparency and foster greater disclosure. They say that credit rating agencies should:

Provide enhanced, clear, concise, and standardised disclosure of rating methodologies

Disclose results of due diligence and examination of underlying asset data examinations, and limitations on available data

Provide disclosure of surveillance procedures; this will foster transparency, and allow market users of ratings to understand their bases and limitations

Provide access to data regarding credit rating agency performance; this will allow investors to assess how raters differ both in the performance of their initial ratings, and in their ongoing surveillance of existing ratings

Address conflicts of interest with a sensitivity towards the difference between ‘core’ credit rating agency services and consulting and advisory services

Disclose fee structures and the identities of top payers to their regulators

Ensure that ratings performance of structured products is consistently in line with ratings performance of other asset classes; this will increase investor confidence in the reliability of ratings
SIFMA also recommends that:

Lawmakers, regulators, and law enforcers across the globe should coordinate more closely in addressing this global problem, in order to avoid counter-productive, piecemeal, inconsistent attempts at remediation

Investors should understand the limits of ratings, and use them as just one of many inputs and considerations as they conduct their own independent analyses, and

All members of the financial industry involved in the generation and use of ratings, including issuers and underwriters, should examine their processes with an eye towards improvement, including working towards standardising reporting and disclosure on underlying assets