Despite an abysmal track record in recent years, credit rating agencies are still wielding unrivalled power. Vanessa Drucker reports from New York on the problems associated with the ratings system and how they can be rectified.
Aο»Ώs the American government prepared to bail out AIG for the fourth time on March 1, 2009, over that weekend government officials consulted closely with Moody's and Standard & Poor's (S&P). They needed to make sure the rating agencies would not downgrade AIG, thereby affecting its liquidity or driving customers to cancel policies. Once again, the federal negotiators were begging to be anointed. Imagine going to a religious figure who has been defrocked and asking for absolution! A year later, as sovereign debt risks emerge as the latest danger, investors anxiously await credit rating agencies' (CRAs) position on the debt of Greece, Britain or even America. It is a paradox. Despite an abysmal track record in recent years, those agencies still wield unrivalled power and influence. They remain the only game in town, as regulatory reforms advance at a glacial pace. This discussion attempts to sketch out some of the thorniest areas crying for reform, and then to suggest a few solutions. First, the agencies' business models are riddled with conflicts of interest, says Richard Herring of the Wharton School at the University of Pennsylvania. Although the agencies had originally sold manuals with credit assessments to investors, by the 1970s they had switched to a model whereby issuers paid them instead. Herring describes the mixed incentives of the diverse constituencies: "Issuers want the highest rating they can obtain, and prefer to conceal or sugarcoat adverse information to keep their borrowing costs low."
ο»Ώ"The lesson is that you can preserve a business that is supported by regulation, which, if subject to real competition, wouldn't survive"
Unregulated investors seek accurate risk information to substitute for their own due diligence, while regulated investors crave high ratings to conserve and maximise returns on regulatory capital. (Still, it has not been openly documented that any CRA ever changed a rating for a fee - notwithstanding all the exposure, congressional hearings and published emails.) A reversion to an investor funding model might address some of these issues, and some of the more recently designated CRAs, like Egan-Jones and Realpoint, do indeed charge investors. However, even if investors did pay for the services, all parties profit as the business gets larger. The real challenge is to keep the pie at a reasonable size. Of course an ideal solution might be for public, non-profit organisations to perform the function, but that is nowhere foreseeable at present.Another key problem is that ratings from the big three - Moody's, S&P and Fitch - have been hardwired into so much banking and private investment regulation. (article continues below)
"The lesson is that you can preserve a business that is supported by regulation, which, if subject to real competition, wouldn't survive," says Frank Partnoy, a law professor at the University of San Diego. That construct will need massive overhauls. But we cannot even blame the CRAs themselves that the structure has become so dependent on them - nobody ever actually asked CRAs if they wanted to be used across the board in regulatory schemes.
For example, the Basel II Standardised Approach, which measures the adequacy of bank capital, assigns a capital charge to each asset, weighted according to its rating. The investment guideline trap operates well beyond international banking, all the way through local governments and private investments. American state pension fund guidelines, for example, are determined by individual state legislatures. That means any smaller, competing CRA would need to petition state lawmakers with expensive lobbyists to find someone willing to change the current law.
As with other aspects of financial reform, the global nature of the industry has compounded the difficulty. In 2004, the International Organization of Securities Commissions (Iosco) developed a code of conduct for securitised ratings, focusing on quality, integrity and independence. Although revised in 2008, "Iosco is so large, with so many players and interests, that it lacks the resources and legal authority for enforcement," says Herring. G-20 summits in Washington and London have followed, rich in rhetoric and pledges but short on implementation.
The 2008 financial collapse highlighted one of the glaring deficiencies of the current ranking system. By relying on the same nomenclature of ratings of corporate, sovereign or municipal bonds and structured debt, investors wrongly took for granted that a Aaa or a BB represented the same degrees of creditworthiness in all classes.
"Until the mid 1990s, their track record in corporates was pretty good, justifying their reputation and franchise," says Jerome Fons, a former managing director of credit policy at Moody's. "Even in the late 1990s they avoided getting caught up in the dotcoms. But they misrated the telecom sector (for example, Enron and Worldcom), which helped lead to the Credit Agency Reform Act of 2006."
ο»Ώ"With expenses fairly fixed and revenues not improving, municipal bonds are an accident waiting to happen"
Then came a host of debacles, ranging from AIG, Lehman and Bear Stearns to Washington Mutual, Fannie Mae and Freddie Mac. Do not forget that Iceland garnered a AAA in early 2007, on the sovereign side. But all that pales next to structured finance.
Gary Gorton, a professor of finance at the Yale School of Management, agrees that "the CDOs [Collateralised Debt Obligation] were a disaster". Gorton sat on the Moody's academic advisory panel from 2003 until January 2007, when he resigned because he regarded their structured finance ratings as "not precise or sophisticated enough. They used rules of thumbs they could have improved on". A particular stumbling block for structured products was the dearth of ready professionals who understood the industry, with a paucity of peers in the market to enforce quality through a peer review process. On the other hand, everyone who goes to business school has been trained in asset pricing for corporate loans. "The lawyers were the only ones who really understood the structured side," says Gorton.
Yet it is fruitless to keep fighting the last war. It is likely the CRAs and the market will treat the structured products with caution for years to come, and the next disaster will be in another asset class altogether. The ticking time bomb may well prove to be municipal debt, which includes about 50,000 issues outstanding at any time.
"Only a year ago, municipalities were proclaiming that they had experienced very few defaults over time, and that the rating agencies were treating them harshly. Exactly the same arguments were applied to asset backed securities [ABS] a few years back," says LECG's Peter Hagan, who was formerly chairman and chief executive officer of Merrill Lynch USA, when it was holding $50 billion (Β£33 billion) of ABS. "People have not focused enough on the unions' salary, retirement pension and healthcare obligations, and implications for bondholders," he says. With expenses fairly fixed and revenues not improving, municipal bonds are an accident waiting to happen. If the government does bail them out the AAA ratings are valid; if not, they represent more variation in asset quality than is reflected today.
Systemic risk, a pernicious danger that reaches beyond the corporate world, is still not being measured. "The dynamic of the whole market may have more impact on the potential for default than the structure of individual securities, or one tranche against another," Hagan points out. Where an industry is internally homogeneous, the risks may be more systemic than for individual issues. For instance, when housing was strong virtually no one defaulted on mortgage backed securities, but when the market turned, a high percentage of homeowners did so.
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Along with neglecting systemic risks, the CRAs gave inadequate heed to ongoing surveillance in a fluid environment. Sylvain Raynes and Ann Rutledge were working at Moody's in the late 1990s until they founded R&R Consulting in New York 10 years ago. Rutledge explains how, in a properly structured deal, all the tranches except for the first loss piece should improve as amortisation capital goes down. She recalls discussions from her Moody's days, that the ratings were "fine for origination but meaningless after that." In other words, a decade ago the ratings were too conservative. "But since no one knew what they were worth in the secondary market, no one knew when they became under-collateralised either," she says.
Surveillance dominates analysis at Realpoint, based in Horsham, Pennsylvania, and one of the newer CRAs. The firm follows all the commercial mortgage -backed securities (CMBS) deals for a clientele of over 250 American institutions. "The Big Three all concentrated on getting out as many deals as possible, instead of focusing on surveillance," says Robert Dobilas, president and CEO of Realpoint. "Here we have built a niche business on surveillance. Nobody else is performing our type of analysis on a monthly basis. Other rating agencies, who report on an annual basis, are compelled to readjust their methodologies all at once, while we are able to show a gradual decline."
The list of challenges, briefly surveyed above, is complex. It is unsurprising that regulators are struggling to address them, but it is disappointing that reforms enacted hitherto have been fairly toothless. In Washington DC, "the rating agencies have been very effectively working around the clock to lobby members of Congress. From the other side, the interests of investors are so divergent that they don't have such lobbying representatives," Partnoy says.
ο»Ώ"Moody's and S&P enjoy a 75-year head start. It has become a natural monopoly, based on reputation"
On the European front, the European Parliament is requiring that CRAs register with the Committee of European Securities Regulators (CESR) as well as with their own member nations. The national regulators will oversee disclosure and methodologies while the CRAs must lodge a data repository of outcomes with the CESR, which will be accessible to the public, and they must publish an annual transparency report.
Across the ocean, the American House of Representatives has finalised a bill ahead of the Senate's ultimate version. Current provisions cover disclosure, registration and transparency requirements. A CRA would be obliged to reveal how the sponsor, issuer and underwriter of structured securities arrive at the accuracy and integrity of their data. The rating agencies would become subject to enforcement actions, penalties and legal liabilities, including actions for gross negligence. Herring considers "the single most daring feature of the House bill" to be the removal of the many statutory references to CRAs in so much of today's regulation.
But the most radical reforms are likely to originate from the outcome of litigation, rather than legislation that has been watered down by lobby groups. A raft of current lawsuits might revolutionise the way CRAs interact. So far, they have been able to stand behind the First Amendment shield, which holds that ratings are entitled to the same protections on free speech as the media enjoy. "That argument, while specious, has been successful," says Partnoy. As long as courts and juries are willing to buy it, little may change.
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An October 2009 opinion in the case Abu Dhabi Commercial Banks vs. Morgan Stanley & Co, by Judge Shira Scheindlin, rejected the First Amendment defense. The judge wrote that the defendants, Moody's and S&P, could be liable if the opinion "is without basis in fact". Partnoy says: "Scheindlin recognised the argument that ratings for structured finance are privately issued, with the agencies involved in the methodologies before and the monitoring afterwards, with their fingerprints all over." If courts do hold that CRAs' roles go beyond journalistic practices, they could be held liable and become subject to draconian fines that might change the shape of the market.
But some are dubious about whether First Amendment challenges would cause more damage than good. "It would be a feast for the tort lawyers, making agencies inappropriately conservative," warns Hagan. "An immediate lawsuit would be brought against the rating agencies when any company failed."
Pending legal developments, what regulation could serve to revamp the state of the ratings landscape and create a more reliable industry? One starting point could be a breakdown of the effective oligopoly of the Big Three. In 1975, the American Securities and Exchange Commission (SEC) created a coveted designation known as Nationally Recognized Statistical Rating Organization (NRSRO), an approval that has been extended over the decades to include about a dozen firms. Not every NRSRO is approved to rate every class of security - covering, say, corporate or municipal bonds and structured products - and now new applicants are required to prove a track record before they can obtain a license, which is a chicken and egg dilemma. While it might be helpful to increase the club of NRSROs, to break the stranglehold of the Big Three, "the worst thing to do would be to license unqualified people," Dobilas says.
Yet even gaining the designation is not enough to support a business per se. It is expensive to launch a CRA, requiring an entire compliance department and deep pockets. Meanwhile, Moody's and S&P enjoy a 75-year head start. It has become a natural monopoly, based on reputation. Few capital market participants are willing to invest in a long time horizon, to obtain the reputation, brand and credibility and persuade investors to accept their ratings.
ο»Ώ"People will always be greedy. To blame the crisis on greed is like lamenting too much sex in a brothel"
Still, some are determined to occupy a potential market niche, like Realpoint's Dobilas. His company, active since 2001, obtained NRSRO status in mid 2008. "The designation in fact did nothing to increase our business but allowed us to rate new CMBS issues, rather than waiting for deals to come to market," according to Dobilas. This March, Morningstar agreed to purchase Realpoint for $52 m, creating the base for a much broader franchise. While Realpoint specialises in American CMBS analysis, Morningstar brings a global footprint to the venture.
One suggestion that has been broached for mitigating conflicts of interest and diluting the power of the oligopoly would be a rotational system for NRSROs. An independent third party might be placed in charge of making issuers regularly switch from one CRA to another. While such a regime would encourage a search for best practices, it could only operate after the industry had opened up beyond the Big Three to encompass some new players.
There has also been discussion on addressing incentives and compensation structures on an individual, as opposed to a firm-wide, basis. "People will always be greedy. To blame the crisis on greed is like lamenting too much sex in a brothel," Raynes says. Whereas top down management policy is guided by the clients' hand that feeds it, the analysts in the committees who are making the decisions are also subject to motivation and self interest. It is important that the analysts say what they think, while knowing that the people to whom they report have the power to fire them. They must express a candid opinion, without regard as to whether it will affect their compensation.
Right now, managers' pay is based on growth. But we need a mechanism whereby a rating agency can logically downsize a business sector that is beginning to spin out of control. One hypothetical proposal would be to reserve a proportion of compensation based on the future performance of a security. Consider the transition matrices that describe the movement of adjustments up or down over the years as credit assessments change. Business cycles reflect the speed of the transition, with fewer securities declining during booms and vice versa. Suppose the CRAs were to reset compensation to adjust according to the business cycle, expressed in the transition matrix. Thus, if they were to see a change in the business cycle on the horizon, ratings could take that into account. In other words, in 2006, sensing a bubble, they could have increased credit enhancements.
Some of the above proposals remain a distant prospect. Meanwhile, one important new rule will become a reality on June 2, leading to more transparency in disclosures. On that date, issuers and other arrangers must comply with a recent amendment to the SEC's Rule 17G-5, by maintaining a password protected website containing all the information they have provided to any CRAs they have hired. The other NRSROs, but not the public, will be able to access it. "When the raw inputs are made available across the industry, it is less likely those involved will run off the rails," says Herring. "While it would be unreasonable to ask for the proprietary models, there is no reason for the inputs to bestow monopoly power."
Rutledge agrees that transparency is the key to a healthier system. Markets have been reliant on S&P and Moody's, which used fixed scales with fixed benchmarks for the numerical meanings of AAA, AA, matching quality to the scale. She says: "Triple A was like a gold standard in receivables. If you got it correct, and benchmarked it to stringent numerical definitions, the deal should not go wrong." Suppose the rigorous benchmarks for AAAs could be handed over to the Federal Reserve, the Treasury or G20, to be agreed upon as a public standard.
A theory of value, in booklet form, would be embraced. Everyone should be able to compute the value of structured securities, and arrive at similar results. The final rating scale would be like a table of contents for a Gutenberg Bible, just as that remarkable publication that broke down the monopoly of knowledge of the Renaissance local clergy. If ratings agencies are to provide modern blessings, at least the public could participate more fully in the sacrament.
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