A charmed life
Credit rating agencies are enjoying a heady irony: the very process that before rewarded uncertain financial products is now generating significant revenues 'rating' the risk of buying corporate and government debt.
Despite the widespread criticism they have endured for their part in blithely awarding highly risky and flawed financial products solid gold ratings, credit rating agencies – the biggest of which are Moody’s Investors Service and Standard & Poor’s – have seen a surge in revenue, as most debt that is issued – government-backed, bank or corporate – comes with a credit rating for which the borrower pays a fee. Such irony has not been lost on their critics.
The rating agencies remain central to the debt markets and their business models today remain largely intact as they have been quick to propose better self regulation, in spite of widespread claims that they exacerbated the credit crisis. Most of the criticism centres on the fact that Moody’s, S&P and Fitch gave triple A ratings to hundreds of billions of dollars of bonds backed by risky mortgages – securities which have since been downgraded and are now in many cases worthless.
Yet the agencies seem to lead a charmed life: investors have been so reliant on their assessments that their ratings continue to be written into the official criteria used by many investors to define what debt they can and cannot buy. Furthermore, the rating agencies are still central to risk assessments by the very regulators that are trying to persuade investors not to be so overly reliant on the opinions they give.
Model flaws
The role of a credit rating agency is to gauge the creditworthiness 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 – though one might be excused for not noticing.
At the beginning of July 2008 the Securities and Exchange Commission (SEC), the US financial regulator, found that their working practices were far from satisfactory. It found evidence of the same analysts pitching the business, debating the fees and carrying out the analytical work. The regulator also found that since credit raters were “deluged with requests”, corners were cut, leading them “to deviate from their models”.
Other organisations have also carried out their own research, and found similarly worrying results. Financial analyst training organisation the CFA Institute carried out a member opinion poll, which found that more than one in ten respondents had witnessed a credit rating agency change its rating in response to pressure from an investor, issuer, or underwriter.
Attacks on rating agencies focus on two charges. Firstly, agencies receive fees from organisations issuing debt and constructing debt instruments 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, 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.
Secondly, 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 – as used in sub-prime mortgage backed bonds – were bomb-proof. But not all AAA securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols.
It seems that agency oversight is the only avenue left, as attempts to improve self-regulation are unlikely to assuage those outside of the industry. At the end of July 2008 the leading global industry association for capital markets, the Securities Industry and Financial Markets Association, rejected out of hand the idea of changing the traditional ratings scale, or adding a suffix or identifier to structured finance ratings, saying that it would cost too much to implement. The agencies added that their clients were also not in favour – without offering much in the way of actual evidence.
Such abuses and lack of confidence have prompted the US financial regulator to propose new rules for the industry so that conflicts of interest are eliminated and that investors reduce their reliance on the information that the agencies produce. Indeed, the SEC has gone so far to say that “blind reliance” on ratings is not something it should foster. Michael Barr, the US Treasury’s assistant treasury secretary for financial institutions, has said that no matter what the reforms, “we are not going to be able to eliminate the need for investors to use their own judgment. The one thing we want to make clear – no investor should take as a matter of blind faith what the ratings agency’s judgment is.” The European Commission has also announced that it will take steps towards stricter regulation of credit rating agencies by supporting calls to register them and make them answerable to financial market supervisors. Charlie McCreevy, the Commission’s internal market commissioner, has already slammed the industry’s voluntary code of conduct as “a toothless wonder”.
SEC reform
The SEC, which has created a new group of examiners to oversee the sector, is looking for ways to reduce reliance on credit ratings. Mary Shapiro, its chairman, said at a Congressional hearing in July that new rules would be put forward later this summer. She said one would require issuers to disclose preliminary ratings to get rid of “pernicious’’ ratings shopping whereby a company solicits a preliminary rating from an agency but only pays for and discloses the highest rating it receives. She added that issuers will also have to disclose information underlying the ratings; look at sources of revenue disclosure and performance history of ratings over one-, five and 10-year periods; and see how the SEC could get investors to do additional due diligence of their own.
The proposed legislation by the US Treasury to reform rating agencies is not widely regarded as fundamentally changing the business of ratings, even though it does put more controls in place. Already, rating agencies have themselves undertaken reviews aimed at restoring confidence in their ratings, particularly on the structured finance part of the business which includes bonds backed by loans like mortgages and where most of the controversies have been.
“While the Administration’s proposals are well intentioned, they are easily criticised as merely cosmetic,” says Joseph Grundfest, a law professor at Stanford University. “If you really want change you have to recognise that the industry is dominated by two agencies and the SEC should create a new category of agencies owned by investors.” Grundfest says case law has shown that opinions by ratings agencies are protected by the first amendment right to free speech. “No matter how much the SEC fulminates against the rating agencies their first amendment protections will be there,” he says.
Problems unsolved
Some believe that the SEC – and other regulators – have failed to see the real conflicts within the rating agencies, and that any proposals for reform are therefore likely to fail. The status of rating agencies means they have access to information that is not made public, information they do not need to disclose, and this is one reason they are supposed to have better insights into companies and deals than ordinary investors might. It is this special status that some believe should be targeted. When an opinion has regulatory power, which is what ratings have, it has to come with some accountability,” says Arturo Cifuentes, principal with Atacama Partners, a financial advisory firm. “It is not enough to say it is just an opinion, because it carries more weight than that in the financial system.”
Cifuentes adds that the US Federal Reserve has also given the big three an additional prize as the central bank is not willing to accept ratings from the other Nationally Recognised Statistical Rating Organisations. “Add the three-year waiting period requirement that a new agency must meet before it can apply for NRSRO status and you wonder who the regulators work for,” he says.
Most crucially, says Cifuentes, the proposed reforms that were presented to Congress in July are likely to be ineffective as they are based on misunderstandings. For example, he says, much fuss has been made about the fact that, allegedly, bankers pay for the ratings, which, in turn, would create a conflict of interest, though in structured finance transactions (CDOs and the like) bankers do not pay for the ratings. Rating agencies, like everybody else involved in a transaction (lawyers, accountants, trustees, bankers, placement agents and so on) get paid from the proceeds of the bond issuance. As a result, he says, “focus on this non-issue has prevented addressing the real conflict of interest problem”, which is far more serious than regulators think. “Frequently, rating analysts report to managers with profit-and-loss responsibilities. If no Chinese walls exist between the analysis and business side of agencies, the potential for undesirable influences is real,” he says.
Finally, there is a subtle but conceptually unsettling issue at the root of the current regulatory framework which regulators have failed to tackle – the fact that there are just nine risk categories (from very safe to very speculative).
Regulators have not only given the rating agencies the authority to determine to which category a particular bond belongs by whatever method they see fit, but also the authority to define these categories. “When one of the agencies changes the default probability target to define what constitutes a BBB rating, they are doing something far more important than determining if a given bond meets a certain standard. They are in fact changing the standard – that is, changing the regulatory environment rather than monitoring compliance with it,” says Cifuentes.
“This point might seem arcane, yet it is the most serious design flaw in the current regulatory framework,” he adds. “Fresh thinking and radical reforms are needed to revive the credit markets. Leaving them at the mercy of the institutions that showed so much bad judgment in what was supposed to be their core competence seems like a terrible idea.”
Calpers suit
As a result of regulators being unable to enforce any immediate meaningful punitive action, some of the biggest investors and borrowers have decided to sue the rating agencies. In July the largest pension fund in the US, the California Public Employees’ Retirement System (Calpers), filed a suit against the three leading rating agencies over potential losses of more than $1bn over what it says are “wildly inaccurate” triple A ratings. That is just one of many.
As at the beginning of August, S&P said that it was facing about 40 separate law suits from investors and institutions. The lawsuit, filed in a California Superior Court, relates to $1.3bn of notes and commercial paper that was issued by three structured investment vehicles (SIVs) called Cheyne Finance LLC, Stanfield Victoria Funding and Sigma Finance and that the pension fund bought in 2006. At the time, the senior debt of the SIVs was rated triple A, which the lawsuit said amounted to “negligent misrepresentations”. The three SIVs later collapsed and defaulted on their payment obligations to Calpers.
All three rating agencies have denied the allegations. Calpers is suing for damages but did not specify an amount.
SIVs, by nature, were “opaque”, the pension fund said, which meant the rating agencies’ assessment was the only real information available to access creditworthiness. SIVs are leveraged vehicles that held high-yielding asset, often subprime mortgages as was the case with the SIVs that Calpers invested in. “The credit ratings on the SIVs ultimately proved to be wildly inaccurate and unreasonably high,” the lawsuit said.
Calpers argues that rating agencies took an inappropriate role in recent years by helping to structure investment vehicles like SIVs and garnering high fees in the process. Fees for rating SIVs totalled up to $1m in addition to the fee for rating the underlying assets, the suit said. “The rating agencies no longer played a passive role but would help the arrangers structure their deals so that they could rate them as highly as possible,” says the suit.
Lawyers are not hopeful that such suits will succeed. In the past, most have failed because rating agencies are protected by the first amendment right to free speech. Their ratings are an “opinion” and therefore subject to free speech protections. Whether this will continue to be the case is a key factor in the debate about the future of the industry. “We are all watching the Calpers suit,” says Donald Ross, global strategist at Boyd Watterson Asset Management. “It may be dismissed like many other suits have been on the basis of free speech, but it has the potential to restructure the credit rating business model.”
This may be the best hope of holding the agencies to account. Given that international regulators have not queried the model under which ratings are given, and that the industry body is averse to changing much of how agencies operate, recourse through the courts may be the only viable option.
The rating agencies remain central to the debt markets and their business models today remain largely intact as they have been quick to propose better self regulation, in spite of widespread claims that they exacerbated the credit crisis. Most of the criticism centres on the fact that Moody’s, S&P and Fitch gave triple A ratings to hundreds of billions of dollars of bonds backed by risky mortgages – securities which have since been downgraded and are now in many cases worthless.
Yet the agencies seem to lead a charmed life: investors have been so reliant on their assessments that their ratings continue to be written into the official criteria used by many investors to define what debt they can and cannot buy. Furthermore, the rating agencies are still central to risk assessments by the very regulators that are trying to persuade investors not to be so overly reliant on the opinions they give.
Model flaws
The role of a credit rating agency is to gauge the creditworthiness 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 – though one might be excused for not noticing.
At the beginning of July 2008 the Securities and Exchange Commission (SEC), the US financial regulator, found that their working practices were far from satisfactory. It found evidence of the same analysts pitching the business, debating the fees and carrying out the analytical work. The regulator also found that since credit raters were “deluged with requests”, corners were cut, leading them “to deviate from their models”.
Other organisations have also carried out their own research, and found similarly worrying results. Financial analyst training organisation the CFA Institute carried out a member opinion poll, which found that more than one in ten respondents had witnessed a credit rating agency change its rating in response to pressure from an investor, issuer, or underwriter.
Attacks on rating agencies focus on two charges. Firstly, agencies receive fees from organisations issuing debt and constructing debt instruments 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, 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.
Secondly, 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 – as used in sub-prime mortgage backed bonds – were bomb-proof. But not all AAA securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols.
It seems that agency oversight is the only avenue left, as attempts to improve self-regulation are unlikely to assuage those outside of the industry. At the end of July 2008 the leading global industry association for capital markets, the Securities Industry and Financial Markets Association, rejected out of hand the idea of changing the traditional ratings scale, or adding a suffix or identifier to structured finance ratings, saying that it would cost too much to implement. The agencies added that their clients were also not in favour – without offering much in the way of actual evidence.
Such abuses and lack of confidence have prompted the US financial regulator to propose new rules for the industry so that conflicts of interest are eliminated and that investors reduce their reliance on the information that the agencies produce. Indeed, the SEC has gone so far to say that “blind reliance” on ratings is not something it should foster. Michael Barr, the US Treasury’s assistant treasury secretary for financial institutions, has said that no matter what the reforms, “we are not going to be able to eliminate the need for investors to use their own judgment. The one thing we want to make clear – no investor should take as a matter of blind faith what the ratings agency’s judgment is.” The European Commission has also announced that it will take steps towards stricter regulation of credit rating agencies by supporting calls to register them and make them answerable to financial market supervisors. Charlie McCreevy, the Commission’s internal market commissioner, has already slammed the industry’s voluntary code of conduct as “a toothless wonder”.
SEC reform
The SEC, which has created a new group of examiners to oversee the sector, is looking for ways to reduce reliance on credit ratings. Mary Shapiro, its chairman, said at a Congressional hearing in July that new rules would be put forward later this summer. She said one would require issuers to disclose preliminary ratings to get rid of “pernicious’’ ratings shopping whereby a company solicits a preliminary rating from an agency but only pays for and discloses the highest rating it receives. She added that issuers will also have to disclose information underlying the ratings; look at sources of revenue disclosure and performance history of ratings over one-, five and 10-year periods; and see how the SEC could get investors to do additional due diligence of their own.
The proposed legislation by the US Treasury to reform rating agencies is not widely regarded as fundamentally changing the business of ratings, even though it does put more controls in place. Already, rating agencies have themselves undertaken reviews aimed at restoring confidence in their ratings, particularly on the structured finance part of the business which includes bonds backed by loans like mortgages and where most of the controversies have been.
“While the Administration’s proposals are well intentioned, they are easily criticised as merely cosmetic,” says Joseph Grundfest, a law professor at Stanford University. “If you really want change you have to recognise that the industry is dominated by two agencies and the SEC should create a new category of agencies owned by investors.” Grundfest says case law has shown that opinions by ratings agencies are protected by the first amendment right to free speech. “No matter how much the SEC fulminates against the rating agencies their first amendment protections will be there,” he says.
Problems unsolved
Some believe that the SEC – and other regulators – have failed to see the real conflicts within the rating agencies, and that any proposals for reform are therefore likely to fail. The status of rating agencies means they have access to information that is not made public, information they do not need to disclose, and this is one reason they are supposed to have better insights into companies and deals than ordinary investors might. It is this special status that some believe should be targeted. When an opinion has regulatory power, which is what ratings have, it has to come with some accountability,” says Arturo Cifuentes, principal with Atacama Partners, a financial advisory firm. “It is not enough to say it is just an opinion, because it carries more weight than that in the financial system.”
Cifuentes adds that the US Federal Reserve has also given the big three an additional prize as the central bank is not willing to accept ratings from the other Nationally Recognised Statistical Rating Organisations. “Add the three-year waiting period requirement that a new agency must meet before it can apply for NRSRO status and you wonder who the regulators work for,” he says.
Most crucially, says Cifuentes, the proposed reforms that were presented to Congress in July are likely to be ineffective as they are based on misunderstandings. For example, he says, much fuss has been made about the fact that, allegedly, bankers pay for the ratings, which, in turn, would create a conflict of interest, though in structured finance transactions (CDOs and the like) bankers do not pay for the ratings. Rating agencies, like everybody else involved in a transaction (lawyers, accountants, trustees, bankers, placement agents and so on) get paid from the proceeds of the bond issuance. As a result, he says, “focus on this non-issue has prevented addressing the real conflict of interest problem”, which is far more serious than regulators think. “Frequently, rating analysts report to managers with profit-and-loss responsibilities. If no Chinese walls exist between the analysis and business side of agencies, the potential for undesirable influences is real,” he says.
Finally, there is a subtle but conceptually unsettling issue at the root of the current regulatory framework which regulators have failed to tackle – the fact that there are just nine risk categories (from very safe to very speculative).
Regulators have not only given the rating agencies the authority to determine to which category a particular bond belongs by whatever method they see fit, but also the authority to define these categories. “When one of the agencies changes the default probability target to define what constitutes a BBB rating, they are doing something far more important than determining if a given bond meets a certain standard. They are in fact changing the standard – that is, changing the regulatory environment rather than monitoring compliance with it,” says Cifuentes.
“This point might seem arcane, yet it is the most serious design flaw in the current regulatory framework,” he adds. “Fresh thinking and radical reforms are needed to revive the credit markets. Leaving them at the mercy of the institutions that showed so much bad judgment in what was supposed to be their core competence seems like a terrible idea.”
Calpers suit
As a result of regulators being unable to enforce any immediate meaningful punitive action, some of the biggest investors and borrowers have decided to sue the rating agencies. In July the largest pension fund in the US, the California Public Employees’ Retirement System (Calpers), filed a suit against the three leading rating agencies over potential losses of more than $1bn over what it says are “wildly inaccurate” triple A ratings. That is just one of many.
As at the beginning of August, S&P said that it was facing about 40 separate law suits from investors and institutions. The lawsuit, filed in a California Superior Court, relates to $1.3bn of notes and commercial paper that was issued by three structured investment vehicles (SIVs) called Cheyne Finance LLC, Stanfield Victoria Funding and Sigma Finance and that the pension fund bought in 2006. At the time, the senior debt of the SIVs was rated triple A, which the lawsuit said amounted to “negligent misrepresentations”. The three SIVs later collapsed and defaulted on their payment obligations to Calpers.
All three rating agencies have denied the allegations. Calpers is suing for damages but did not specify an amount.
SIVs, by nature, were “opaque”, the pension fund said, which meant the rating agencies’ assessment was the only real information available to access creditworthiness. SIVs are leveraged vehicles that held high-yielding asset, often subprime mortgages as was the case with the SIVs that Calpers invested in. “The credit ratings on the SIVs ultimately proved to be wildly inaccurate and unreasonably high,” the lawsuit said.
Calpers argues that rating agencies took an inappropriate role in recent years by helping to structure investment vehicles like SIVs and garnering high fees in the process. Fees for rating SIVs totalled up to $1m in addition to the fee for rating the underlying assets, the suit said. “The rating agencies no longer played a passive role but would help the arrangers structure their deals so that they could rate them as highly as possible,” says the suit.
Lawyers are not hopeful that such suits will succeed. In the past, most have failed because rating agencies are protected by the first amendment right to free speech. Their ratings are an “opinion” and therefore subject to free speech protections. Whether this will continue to be the case is a key factor in the debate about the future of the industry. “We are all watching the Calpers suit,” says Donald Ross, global strategist at Boyd Watterson Asset Management. “It may be dismissed like many other suits have been on the basis of free speech, but it has the potential to restructure the credit rating business model.”
This may be the best hope of holding the agencies to account. Given that international regulators have not queried the model under which ratings are given, and that the industry body is averse to changing much of how agencies operate, recourse through the courts may be the only viable option.
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