Credit Check - Philip Hoult

Ratings agencies have been criticised for their role in the financial crisis and now face direct regulation for the first time. The severity of the global financial crisis meant that politicians, the media and the public at large would inevitably seek to apportion blame. Credit rating agencies – along with bankers and regulators – were soon cast as the villains of the piece. After all, the critics asked, how could sub-prime mortgage securities in the United States be rated AAA one day and apparently worthless the next? And surely a model where the issuer rather than the investor pays for the rating presents a huge, if not irreconcilable, conflict of interest. The agencies’ protestations that many investors had failed to understand what the ratings meant – that is, they only covered the probability of an entity or instrument’s default and not its liquidity or market value – were largely drowned out as calls for direct regulation of their activities became insistent. Peder Hammarskiöld, senior partner of Swedish firm Hammarskiöld & Co and a member of the IBA’s Task Force on the Financial Crisis, has some sympathy with the agencies’ view. ‘The market has used credit ratings agencies in the wrong way’, he says. ‘Many of the market players have over-relied on the agencies’ stamp of approval and have not done their own homework. They have assumed everything is fine because of the rating, and have not done their own credit analysis or sufficient due diligence.’ But Hammarskiöld also believes the leading agencies – with the possible exception of Fitch – had become ‘over-commercial’ during the boom years by taking an active part in the invention of new instruments. ‘They were happy to earn a lot of money in rating these very exotic instruments that no one wants to invent any more’, he adds. ‘The blame should be evenly put on the agencies and the market.’ Philip Wood, special global counsel at Allen & Overy (A&O) and another member of the IBA’s task force, agrees. ‘It would be very unfair to pick the credit ratings agencies out’, he suggests. ‘Sure, they got it horribly wrong at times, but then so did everyone else. The bubble was caused because the whole of society got carried away.’ This is not the first time that the role of credit rating agencies in the financial system has come under the spotlight, however. The collapse of Enron and then Parmalat in 2004 in particular prompted a debate about what oversight, if any, was appropriate.

At the time, the European Union’s Commissioner for the Internal Market, Charlie McCreevy, suggested that a combination of existing financial services directives that indirectly affected credit ratings agencies – the Market Abuse Directive and the Capital Markets Directive – and a voluntary code introduced by the International Organization of Securities Commissions (IOSCO) ‘will provide an answer to all the major issues of concern’.

Time to get tough

The financial crisis put paid to that optimistic assessment and made a voluntary code of conduct politically unacceptable. At a meeting in Washington, DC in November 2008, G20 leaders vowed to ‘exercise strong oversight over credit rating agencies’.

Commissioner McCreevy is among those to have changed their tune. Describing the IOSCO code as ‘a toothless wonder’, he pressed ahead with plans for direct regulation. This led, in April 2009, to the European Parliament approving a new regime that requires credit ratings agencies to apply for registration with and submit to ongoing supervision by the Committee of European Securities Regulators.

Agencies operating in the European Union now have to comply with ‘rigorous rules’ aimed at improving the quality and transparency of ratings and reducing the impact of conflicts of interest. These include bans on providing advisory services for entities and instruments they rate, and rating financial instruments if they do not have sufficient information at their disposal.

Credit ratings agencies are expected to disclose their models, methodologies and key assumptions and differentiate more complex products with additional symbols. The European Union’s shake-up also requires them to publish an annual transparency report, establish an internal review function to look at the quality of its ratings, and appoint independent directors to the board whose remuneration is not dependent on the agency’s financial performance.

The European Union’s regime will have teeth – agencies risk large fines or even deregistration if they fail to comply, although Edmund Parker, head of derivatives at the London office of Mayer Brown, believes that it should not prove too difficult for the main agencies to adapt. However, he does have concerns about some of the provisions and whether they will have the desired effect.

‘I just can’t see the logic for these additional symbols for structured finance products’, he says. Pointing out that such symbols would not appear to make any difference for regulatory capital purposes, Parker fears that they are only likely to cause confusion among investors. ‘If the rating of a structured product is qualitatively inferior, why would this not be reflected in a lower rating itself? If it is not inferior, why do we need the additional symbol? This seems to be being done at the behest of those who blame credit ratings agencies for the woes of the structured finance markets.’

Perhaps more importantly, Parker fears that the emphasis on transparency and disclosure may in itself cause some problems that emerged during the credit crunch to be repeated. ‘One of the reasons why markets were shocked at ratings changes is that so many structured products were designed along similar lines’, he suggests. ‘If there was a flaw in a structure and one of those products was downgraded, they all got downgraded. As credit ratings agencies set out clearly [under the European Union’s new regime] what their rating methodologies and approaches are, arrangers can structure products accordingly.’ If some instruments become standardised as a result, all based on the same methodology, any unforeseen flaws could also be replicated. This is surely not what the EU regime intends.

‘If you can’t do your own research, you shouldn’t be in that market. You will never have regulation that completely protects people from their own stupidity’ Peder Hammarskiöld Hammarskiöld & Co

Slipping through the net

Another concern is that despite the G20’s promise to provide a coordinated response to the financial crisis, there may well be a lack of global consistency when it comes to regulating credit rating agencies. Australia, Japan and the United States are among the countries to have introduced new rules recently and there is a widely held view that the regime in the United States in particular is much less stringent than that brought in by the European Union.

The Securities and Exchange Commission (SEC) initially proposed wide-ranging and radical changes, but its first set of rules – issued in December last year – were considered by many to be substantially watered down. Unlike the European Union, it only requires agencies to disclose the workings for ten per cent of issuer-paid credit ratings. Other key provisions include a bar on agencies rating debt they helped structure and on analysts accepting gifts worth more than US$25. The SEC has left open the prospect of a more demanding regime in future, but concrete plans are yet to emerge.

The differences between the US and EU approaches have led some commentators to predict that there will be opportunities for ‘regulatory arbitrage’, with issuers perhaps taking advantage of a less stringent regime to obtain their ratings. Alternatively, perceived differences in the trustworthiness of ratings may drive them to a tougher regime as they seek to attract investors.

Paying the piper

How the reforms are enforced in practice is likely to be critical to their success. A&O’s Wood, for one, is sceptical, arguing that the changes fall into the ‘something-must-be-done’ category. ‘On this occasion the politicians and taxpayers were hopping mad and called on the regulators to do something’, he claims. ‘But a lot of this is air.’

Questions over the appropriateness of the issuer-paid model and the level of competition possible in an industry dominated by three players – Moody’s, Standard & Poor (S&P)’s and Fitch – also persist. George White, a partner at Sullivan & Cromwell and Co-Chair of the IBA’s Capital Markets Forum, believes that greater regulatory scrutiny of rating agencies should have a beneficial effect but says neither the European Union nor the SEC has really grappled with the issue of how they are compensated. ‘Industry participants will tell you that there’s no alternative to the issuer-pays structure because the people who utilise the ratings are a very diverse, fragmented group’, he says. ‘No one has yet come up with a scheme that shows any sign of being successful for a user-pay model of compensation.’

There has been talk about the creation of a rival agency or agencies run by investors, but this approach would have its own problems. For example, what incentive would there be for the owners to continue to make their ratings freely available?

The June 2008 settlement agreement between the three leading agencies and the Attorney-General of New York, Andrew Cuomo, over the way they rate residential mortgage-backed securities adopted another approach to the attempt to mitigate the conflict of interest over payment. Among other provisions, the deal required agencies to establish a fee-for-service structure, where they are paid even if the investment bank does not select them to rate the securities in question.

The compensation element of ratings agencies’ operations may have to be looked at again and more widely than for mortgage-backed securities. In the meantime, the agencies have promised to raise their game. Speaking at a conference in Paris in July this year, Tony Angel, head of Europe, Middle East and Africa at S&P, acknowledged that confidence in ratings agencies had been dented. ‘Most of our ratings actually have held up well in the crisis’, he insisted. ‘But the performance of ratings on many recent US housing-related structured securities has been poor and out of line with our historic track record. That is something we very much regret.’

Angel, former managing partner at Linklaters, said the agency is implementing ‘the most radical set of changes in S&P’s 150-year history’ as a result. These 30 or so initiatives include:

• the adoption of criteria that incorporate credit stability, not just the likelihood of ultimate default, into its ratings analysis;
• an analyst certification programme with New York University; and
• an independent ombudsman reporting to the company’s audit committee.
  

Invest wisely

A renewed focus by credit ratings agencies on the core issues of quality, transparency, integrity and accountability in this way will no doubt be widely welcomed. However, Hammarskiöld, Parker and others argue that it is also up to investors to step up to the plate – by doing their own due diligence and using ratings as just one of the tools with which to make their decisions.

Whether anyone other than the most sophisticated investors will take notice of the enhanced disclosure of agencies’ models (as envisaged by the European Union and the SEC) is a moot point. So far, investor behaviour is not something that governments and regulators have sought to address. ‘It is a case of caveat investor’, Hammarskiöld argues. ‘If you can’t do your own research, you shouldn’t be in that market. You will never have regulation that completely protects people from their own stupidity.’

For further information on the IBA’s Task Force on the Financial Crisis see: tinyurl.com/crisistaskforce