Joanna Faith reports on the failure of the ratings agencies in the financial crisis and the need for a complete overhaul of the industry
In the 21 June issue of Investment Week we featured an article from Tony Angel, head of Europe, Middle East and Africa at Standard & Poor’s.
In the article, Angel said that during the financial crisis, credit ratings had “stood up well in the tough conditions and fulfilled their role as benchmarks of default risk”. He backed up his comments with empirical data demonstrating the performance of the ratings agency.
However, he acknowledged the performance of ratings in two specific areas – recent US residential mortgage-backed securities (RMBS) and collateralised debt obligations (CDOs) – had been “disappointing” and that S&P’s had “taken major steps to address that” such as “criteria changes that will make it more difficult to assign high ratings to securities or issuers in sectors that have displayed poor credit performance in the recent past”.
Fine. But is this not all too little, too late? After all, as investment heavyweights such as Bill Gross and Peter Sands agree, RMBS or CDOs – made up of sub-prime mortgages bundled together and sold on to investors – were at the root of the financial crisis. Why did these asset-backed securities get triple-A ratings from agencies in the first place?
Overhaul
Although technically out of recession, the majority of the world is still reeling from the effects of the deepest economic slump since the end of the Second World War. It is not enough for agencies such as S&P’s to claim they have introduced new measures to prevent another economic catastrophe. The industry needs a complete overhaul.
Some argue ratings agencies should be scrapped altogether. Peter Sands, the chief executive of Standard Chartered, would make a start “by banning issuer-paid ratings for structured credit products”.
But Peter Harvey, manager of Cazenove’s Strategic Bond fund, says agencies are necessary and required by large parts of the market.
“It is very sensible to centralise the business of credit ratings. Large insurance companies and pension funds rely on them and need them,” he says. “It is not efficient or sensible for every insurance company in the world to build up a team of 1,000 analysts. You could, however, question whether they naturally fall into the private sector.”
S&P’s says on its website, in our “complex, inter-connected global economy… ratings are an important tool to help investors make informed investment decisions”. Banning ratings agencies – who, at the end of the day, are selling opinions – is not the way forward.
A question of trust
So, if the ratings industry – dominated by the oligopoly of S&P’s, Moody’s and Fitch – is here to stay, should investors be wary because of their abject failure during the credit crunch?
The way ratings agencies are funded is a fundamental bone of contention as there are clearly conflicts of interest. The ratings businesses rely to a large extent on fees from entities and companies selling bonds, the very entities the agencies are rating. The rest of their remuneration comes from investors.
Industry commentators have argued for some time relationships between providers and the rating agencies have become too close; in 2007, between 35% and 40% of the revenue of one of the largest agencies came from structured products.
“Rubber stamping structured products became a central part of their business,” says Harvey. “There was clearly a conflict of interest, which was abused.”
S&P’s says it has strong procedures in place to protect its “robust and independent” analysis. Its measures include an analyst rotation programme and requiring the compliance group to be independent to the ratings business.
But the fact the US Government – under the guise of the Financial Crisis Inquiry Commission – is currently investigating the contribution of ratings agencies in the credit crunch illustrates the magnitude of these companies’ roles during the downturn.
Threat
During one senate hearing, former staff at Moody’s said they felt threatened by bankers to assign top credit ratings, that bad decisions were made in a constant push for market share and that the company lacked sufficient staff to keep up with the explosion in complex debt instruments.
It became a “triple-A factory”, said Eric Kolchinsky, a former managing director. “Bankers knew we could not walk away from a deal… and took advantage of that.”
With the reputation of ratings agencies teetering on a cliff edge, what then are the answers? How can ratings agencies salvage the industry’s trust and regain investors’ faith in the decisions they make?
Regulation has become the buzzword of the recession with commentators calling for stricter parameters surrounding the banking system to prevent another financial crisis. Tougher regulation should be extended to ratings agencies.
Legendary bond investor, Bill Gross of PIMCO, agrees there is a need for regulation. Last month, he described the ratings agency model as broken, meaning investors pay little heed to credit ratings.
“The ratings simply are not respected – there has to be some regulation,” Gross said.
But what form should this regulation take? An independent body that oversees credit ratings?
An autonomous organisation carrying out the ratings? As a consumer of ratings, Harvey says he has a “strong preference for a ratings body that was truly independent of the instruments and corporations being rated”.
He says: “I would prefer a ratings industry paid for by investors only.”
Another measure to increase transparency would be to pay ratings agencies on a performance-related basis. We do not know how good ratings really are until bonds mature or default. The solution should depend on future performance.
Call for autonomy
Harvey does not think this is a good idea. “Agencies need to be independent, unconflicted and paid by investors to make impartial judgements. The moment you start incentivising them with money, distortions will appear.”
Another option is investors could do the ratings themselves and disregard the opinions of agencies.
In fact, evidence suggests European investors are increasingly relying on their own analysis of securitisation deals rather than the rating agencies’. A survey by Bishopsfield Capital Partners, a structured finance consultancy, said almost two-thirds of investors it had spoken to believed the industry had been “truly damaged” by the crisis.
Harvey says: “Generally, across the fund management industry, people have invested more in buy-side research capabilities. I can see a world where the largest investors almost entirely rely on their own analysis.”
