US rating agencies in the dock?

For many people the credit crunch must feel like they were invested in Confederate bonds!
Among the worst of the blameworthy institutions responsible for the crunchiness of the credit crunch are the ratings agencies, Moodys, Fitch, and Standard & Poors. In structured finance Moody's has been the dominant player with perhaps half of the market. Why, are the ratings agencies in trouble - because their models were severely faulty, especially that of Moody's, in particular for confusion between underlying credit risk rating and credit enhancement and the macro-economy, and for having severely critical system design bugs. If you like you may buy various models from the agencies to calculate ratings including for complex instruments. The models you get appear quite comprehensive and suitably complex, but they rely for key input data on your finger-in-the-air assumptions, crude factor inputs, and abstract variables where real world data, especially economics data would be not merely wholly, but are solely, appropriate. The ratings agencies have two main strengths, 1, historical data, critical aspects of which were ignored it seems or failed to be incorporated in pre-2007 models; and 2, legal requirements that valuations throughout the financial services industry should employ ratings agency values, which enforces their market reference position as an oligopoly, collectively a near-monopoly. This does not mean, however, that the financial industry knows adequately what the agencies' strengths and weaknesses are, or necessarily believe their gradings are superior. The industry knows that everyone uses the 3 global raters and that is a power that must be supervised from a regulatory/quality assessment perspective and that their modeling approaches should be more transparent for expert review. New US moves will face the credit rating agencies with new disclosure rules and restrictions but would not be forced to overhaul their business models under proposed US legislation to be sent to Congress on Tuesday. From a European perspective the new rules fall well short of the European Commission's wishes. The main problem for the ratings agencies is whether rule changes in the US will do anything to protect them from law suits coming down the turnpike that should bust the companies if they get to court. In that context why invest in improvements, in anything other than what will defend their sorry records? The plan (of US Treasury) is aimed at managing better issues that were long known:
- conflicts of interest at rating agencies,
- providing regulatory oversight by the SEC and
- reducing the financial system’s reliance on credit ratings.
The plan is one major part of the Obama administration’s financial regulatory blueprint. The ratings agencies overlooked or under-estimated or mis-modeled or wrongly implemented software for assessing the risks of investing in securitisations, in complex, “structured” securities, especially those linked to mortgages. As all should know by now Moody's until June '07 operated a rating model that was indifferent to default rates - a glaring error that caused all securitisation issues (across what should have been 17 grades) to be all classed in one risk bucket, triple-A. The problems to be sorted out about the ratings agencies that were overlooked after LTCM, Enron and the dot com bubble burst have to be tackled this time comprehensively. The severe doubts about the companies' survivability is reflected in their share prices, though these also reflect fall-off in new structured product ratings business. Barney Frank, head of the chairman of the House financial services committee, on Tuesday endorsed the proposed measures to overturn requirements to use the credit ratings agencies. “There are a lot of statutory mandates that people have to rely on credit rating agencies. They’re going to all be repealed,” he told Reuters. This would trigger changes in Basel II statute law in Europe if the EU followed suit. The business models at Moody’s Investors Services, Standard & Poor’s and Fitch Ratings – which are paid by the companies whose debt securities they rate – remain largely intact. There has, however to be severe doubts remaining about these. We know that none of the agencies have macro-economy models that incorporate detailed financial sector statistics! It is unclear too, in the case of structured product bonds, whether credit risk enhancements were modeled when assessing the issues just because standby credit and insurance was part of the issue contracts, or whether the underlying was separately rated first? We do not know what macro-economic modeling correlations were used before the crisis and if these have since been changed? We do not know how comprehensively national credit risk ratings are determined and what the models are that determine watch-lists or if subjective judgments are part of the assessments? Defending the Treasury’s decision not to heed calls by some for a fundamental overhaul, Michael Barr, assistant Treasury secretary for financial institutions, said there were conflicts inherent in alternative models too. But, the conflicts being considered are few in number and yet little analysed. Tuesday’s proposals would bar ratings agencies from providing consulting services to any company they rated and would require them to disclose fees for a rating. It also attempts to stem “ratings shopping’’ in which a company solicits “preliminary ratings’’ from multiple agencies but only pays for and discloses the highest.
Ratings agencies will be required to use different symbols for structured finance products, which are perceived to be riskier, than for corporate bonds. What the point of this is when it merely means that financial service firms will have to construct converters or engage in major risk accounting system overhauls?
The plan is “a continuation of what the SEC has already done to a more limited extent’’, said Lawrence White, professor at New York University’s Stern School of Business, talking to Reuters. His view is that the proposal does not go far enough to reduce the ubiquity of the credit ratings in how they are hardwired into the financial markets via financial regulation (implication: Basel II) and did little to foster competition in the sector. To my knowledge it is worse than that insofar as ratings tables have in many banks been so hardwired that they have become inflexible to change in accordance for example with recent experience, experience that has bust the parameter limits of pre-credit crunch models. The SEC has appointed special auditors to oversee ratings agencies, and last year passed rules prohibiting activities such as executives providing both ratings and advice on how to structure securities, and barring those who evaluate the debt from discussing fees, as well as limiting gifts from debt underwriters to rating agency employees. S&P said it was studying the proposal. Moody’s said it supported the goals of “increased transparency and enhanced ratings quality’’. Fitch said the plans were consistent with its views on transparency. What the news comments do not broach is that there are issues here and others not addressed that go to the heart of the survivability of the credit ratings agencies, and indeed to the heart of investment banking as we have hitherto known it?