Bad credit
Neil Hodge
While the role of the banks has been well documented in bringing about the current global credit crunch, the role of the industry that whetted the banks' appetites to invest in high-risk debt vehicles by giving them fantastic ratings
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 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 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. The European Commission has also announced that it will take a first step 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”. We will have to wait until October – when the Commission unveils its proposed regulation of the industry – to see if its plans amount to anything better.
