D espite 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
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World Finance | Nov - Dec 2009
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.
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