The perfect murder isn't one where the murderer got away;
rather it is one where no one knew a murder took place at all ... -
Anon
Remember those wonderful rating agency "scandals" of
2007-08 when a whole bunch of people opined that that the rating agencies had
committed a "crime" against the investment community by publishing what were
essentially poorly judged (if not fraudulent) ratings of various securities,
that in turn encouraged a vast horde of unsuspecting investors to purchase them
and subsequently lose hundreds of billions of dollars?
Remember all the noise and froth at the time about how these agencies were
going to be regulated, controlled, sued and
whatever other punishment imaginable? Has anyone heard much about a grand
global effort to destroy the rating agencies' flawed business model? No? Well,
me neither.
What has passed for "reforms" is arcane language in the new US Senate bill on
financial sector overhaul, and some toothless ideas from the European Union.
To discuss the rating agency issue, and hopefully bring it center-stage again,
we first need to examine what it is that went wrong. Following the precepts of
the Heisenberg principle, it is valid then for us to start the discussion by
looking at different businesses that operate under similar constraints. As it
turns out, given the rating agencies widely circulated view that "credit
ratings are merely opinions", comparing them with a typical newspaper's dilemma
is valid.
Imagine you were running a newspaper, itself owned by a public company, and
generally scratching along a living by selling your publications for $1 each.
Supplementing the income from your sales is a bunch of advertisements in your
newspaper, with the most prominent one at 40% of your revenues being from a
company that makes a water-based fizzy beverage containing a lot of sugar,
caffeine and all sorts of positively nauseating chemicals that are designed to
extend the shelf life of the product and improve its "taste".
You, as the editor, know all that - but obviously since there is no explicit
harm from the product, you go along and say nothing. A few years of this
comfortable relationship later, the demand for printed newspapers is plummeting
due to this thing called the "Internet" and you find yourself dependent on the
fizzy-water company for 80% of your now rapidly declining profits.
Meanwhile, one of your junior reporters, who is too young to know any better,
comes along with a startling expose that a bunch of scientists working in a
nondescript lab have discovered long-term health problems in people drinking
the fizzy water that is regularly advertised on your pages. Getting wind of the
expose, the company gets in touch with you and tells you not to publish the
"allegations", due to a serious risk of losing future advertisements. So what
do you do?
Typically, an editor who chooses to remain silent would retain the advertiser
but lose his junior reporter. Eventually, the junior reporter will turn out to
be right and find someplace - maybe the Internet if the newspaper is lucky, and
a competing newspaper if they aren't - to publish his views. Over the long
term, readers may (and I use "may" advisedly) find the editorial bias in favor
of fizzy water companies startling and unacceptable and switch loyalties to
another newspaper. Once they do switch though they may find that the other
newspaper is equally biased, just in favor of a different fizzy water company,
and they may well switch back.
The best editors I know would simply slam the phone down on the fizzy water
company and publish the expose as is (after considerable fact-checking). There
is always the possibility of losing the advertisements of the fizzy water
company, but to lose credibility (for such editors) would be unheard of.
Much like the description of the business model of the newspaper above, the
basic business model of the rating agencies is to secure payments from the
users of credit ratings. A typical license to view credit ratings for a bunch
of companies in an industry or a region can cost a fair chunk of money -
between US$15,000 and $150,000 per year, depending on the breadth and depth of
coverage so required.
Where things get a bit hairy is that rating agencies also charge the companies
that are rated by them, charging them an overall corporate (company or firm or
partnership) fee as well as for every individual security that is issued by the
company and purchased by investors. Such fees are fairly high, at more than
$50,000 for even medium-size firms and adapted for an overall fee in the case
of larger companies that may have hundreds of securities issued.
Right there, much like the newspaper editor in the above story, a rating
agency's employee has an inbuilt conflict of interest, namely between the
company he rates (which would want the highest possible credit rating in order
to have the lowest possible borrowing fee) and the investor (whose interests
are best served by extremely stable credit ratings that avoid declines - or
downgrades - for the life of the security, that is, the lowest possible one
below which the company's financial performance will not decline under most
scenarios).
At this stage, the reader may be puzzled - why would all these fantastic sums
of money be paid for a credit rating? The answer is a little artefact of US
insurance law that specifies the use of "Nationally Recognized Statistical
Ratings Organizations", or NRSOs, in assessing the quality of corporate bond
portfolios that were purchased by the insurance industry. Remember that in the
"old" days, the industry was the main holder of corporate bonds, while banks
held loans from these companies.
There being only three NRSOs - Fitch, Standard & Poor's and Moody's - for
much of the past century, intrinsic competition was limited (much like, funnily
enough, in the fizzy water companies where two or three players dominated the
global market for what is essentially a useless product).
To make matters worse, remember the bit about the companies paying the rating
agencies for their ratings: this created, effectively, an upward bias for
ratings as agencies competed with each other to push credit ratings up for
each company, thereby ensuring that the issuers would retain their services.
Whilst nauseating, this was not the worst conflict of interest that the
agencies managed. It was indeed what they did next, namely that they used
historical default rates as the basis for creating a new class of ratings for
structured finance assets. To do that, they used the historical observations of
default rates by rating class, as a forward-looking measure of creditworthiness
based on ratings.
An example of such a cumulative default rate, this one published by Moody's
just before the financial crisis broke out in earnest, is shown below. It has
the cumulative default rates, that is the total default for the time period.
The second bit of statistical jiggery-pokery involves something called the
"transition" matrix of credit ratings, namely the risk that a security that is
rated at X at the beginning of the year sees a rating change to X-1 or X+1 or
whatever at the end of that year. The most commonly used such ratings
transition matrix, at least as available publicly, and published on
www.riskglossary.com, is shown below for the one-year timeline: (One year
ratings transition matrix)
One-year ratings migration probabilities based on bond rating data from
1981-2000. Data is adjusted for rating withdrawals. Numbers in each row should
sum to 100%. Due to round-off error, they may not do so exactly. Source:
Standard & Poor's.
The second table basically implies that a credit starting at say a rating of
triple-A would most likely end the year at triple-A (93% probability) and have
pretty much no chance of declining in credit rating below double-B. In the
middle of the table, the numbers are more volatile, but still relatively
acceptable. The essential "lesson" if any from this table is that credit
ratings were generally stable. As many investors were to discover from 2007
onwards, that was a significant illusion.
If you could assume that credit ratings would remain stable, it then became
fairly trivial to calculate your potential losses. In simpler terms, the logic
went, because the five-year default rate of a triple-B rated security was
approximately 1.94%, any security rated triple-B was only likely to have a
default rate of 1.94%. Extending that bit of "logic", it was then apparent that
any security with a historical default rate of 1.94% over five years would
deserve to be rated at triple-B. (Note here that such statistical default rates
are different for each category of financial asset, and the article uses the
example of corporate bonds as published by Moody's; the default rates would be
vastly different for other types of securities).
For anyone still counting, that is two leaps of faith in a single act, that is,
firstly that the past tends to replicate in the future, and secondly that a
historical observation has a causative effect on scores. These aren't idle
points for statisticians, but were clearly overlooked in the leap to the world
of credit ratings.
The key question is why did the credit rating agencies go for this malarkey?
And the answer is simple - the people who issued these securities, namely the
Wall Street banks, were the ones paying them for the credit ratings. That is
where the random thievery involved in the conflict of interests on corporate
bond ratings became an outright systemic robbery when applied to the world of
structured finance and, in particular, to securities that were built on the
subprime and Alt-A loans made in the US residential mortgage sector.
The rest, as the good bard would say, is history. Brandishing what were
essentially fake if not fraudulent credit ratings on a whole bunch of
securities, Wall Street managed to peddle the most toxic assets in the
financial world to the most risk-averse people. The type of investors who would
lose sleep over an "emerging market" bond rated at triple-B went and gladly
purchased the "triple-A" mortgage-backed securities issued by Wall Street,
completely unaware of the risks entailed due to the false sense of security
provided by the credit ratings.
As poetic justice would have it though, most of Wall Street also ended up
eating its own cooking, that is, purchasing the very same assets that were
designed in other departments of the firm, eventually leading to the closures
of Bear Stearns (acquired by JP Morgan), Merrill Lynch (acquired by Bank of
America) and Lehman Brothers, and nearly sending the other two large investment
banks - Goldman Sachs and Morgan Stanley - to the footnotes of financial
history.
Subsequently, much anger has been expended on the surviving banks, on subjects
ranging from executive compensation to the quality of toilet furnishings in a
chief executive's office. Really.
Yet, apart from a brief flirtation with the infamy of appearing before the US
Congress and having a couple of toothless European politicians criticizing
them, credit rating agencies have escaped meaningful reforms altogether. Using
a term like "cosmetic" doesn't half do justice to the sheer lack of action
surrounding potential reforms of the credit rating agencies.
Lexology.com reports on the financial reform bill of senate banking committee
chairman Chris Dodd, condensing the provisions on credit rating agencies thus:
Chairman
[Chris] Dodd's legislation includes credit rating agency (CRA) provisions
similar to those released last fall in his previous draft designed to increase
transparency and accountability of CRAs. Most notably, the bill establishes a
new Office of Credit Rating Agencies at the SEC [Securities and Exchange
Commission]. This office would be given the authority to fine or penalize a
credit rating agency for various violations or if the SEC finds that the CRA
lacks adequate financial and managerial resources to consistently produce
credit ratings with integrity.
To increase transparency, CRAs would be required to issue a report with each
credit rating that discloses their methodologies, including assumptions
underlying the credit rating, the data relied upon in analysis, the use of
servicer or remittance reports, and any other information that can assist users
in analyzing the credit rating. Additionally, a CRA would have to reveal when
it relies upon diligence review services performed by a third party. Similarly,
CRAs would also be required to notify the users of the credit ratings of any
material change in procedure or methodology, or errors made in the formulation
of credit ratings. Each CRA must also ensure that changes to methodology are
applied consistently to all credit ratings.
The legislation further would prohibit CRA compliance officers from working on
the formulation of credit rating or methodologies, to minimize any potential
conflict of interest. CRAs would also be required to utilize information
obtained from third party sources if the CRA deems the source credible.
Notably, the legislation includes a provision permitting a private right of
action by an investor if a CRA knowingly or recklessly fails to investigate the
quality of data provided or to obtain analysis of the information from a
neutral, independent source. It also gives the SEC the authority to de-register
an agency that has provided bad ratings over a given period of time.
In effect, the only change is that credit rating agencies can now be sued for
their ratings. If that made you laugh out loud for its sheer inadequacy, wait
till you read the proposals from the European Union, dated July 27, 2009:
Credit
rating agencies
Credit rating agencies play an important role in securities and banking
markets, as their ratings are used by investors, borrowers, issuers and
governments in taking decisions on investment and financing. They are however
considered to have failed to reflect early enough in their ratings the
worsening of market conditions in the run-up to the financial crisis.
The regulation is aimed at ensuring that credit ratings used in the European
Union for regulatory purposes are of the highest quality, and issued by
agencies that are subject to stringent requirements.
Currently, credit rating agencies are only to a limited extent subject to EU
legislation and most member states do not regulate their activities, although
their ratings are used by financial institutions that themselves are subject to
EU rules. The agencies, most of which have their headquarters outside the EU,
may however apply a voluntary code of conduct issued by the International
Organization of Securities Commissions.
The regulation comes in response to calls from both the European Council and
the G-20 (Group of 20 countries). It establishes a common framework for
measures adopted at national level, in order to ensure the smooth functioning
of the EU's internal market with comparable levels of investor and consumer
protection from one member state to another.
It provides for a legally-binding registration and surveillance system for
credit rating agencies issuing ratings that are intended for use for regulatory
purposes.
It is also aimed at:
Ensuring that credit rating agencies avoid conflicts of interest in the rating
process, or at least manage them adequately.
Improving the quality of methodologies used by credit rating agencies and the
quality of their ratings;
Increasing transparency by setting disclosure obligations for credit rating
agencies.
By this time, the credit rating agencies are
quaking in their boots. Or not. After all, it was always possible that
governments would do the following to them in the wake of the epic scandals
discovered on credit ratings from 2007 onwards:
Shut them down altogether.
Force them to choose between investor and issuer-side businesses (effect, same
as a above).
Revoke their NRSO status (and equivalent in other countries).
Send a few rating agency analysts to prison or bar them from the industry
altogether going forward.
Nationalize them.
Whatever has passed so far is far from comforting for future bond investors.
While it could just be that government officials are too busy to have noticed
the rating agencies, another factor could also be at play. Clearly, what has
passed as financial market regulation for the rating agencies has been tempered
by the need for the very same governments in the bond markets to continue their
borrowings.
In other words, there is a conflict of interest in the US and highly indebted
European governments being in charge of reforming the credit rating agencies in
the first place, given their own borrowing needs, which would be adversely
affected by potential rating downgrades should the demands for "truth" in
credit ratings become too onerous or even inflexible.
If ever there was an issue for Asian countries to take a lead on, this is it.
Given the vast holdings of US and European government debt that is held by
Japan, China, South Korea, India and other Asian countries, it is time that
they bandied about and created their own assessment of what the true
creditworthiness of Western nations really was. In the process, whatever new
rating agency that is created could well turn out to be an effective
replacement of the existing three agencies.
If and when these companies pass away into the financial history books, there
probably won't be too many tears shed in Asia.
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