Max Bowie: Will Ratings Rethink Restore Credit Confidence?

As someone who leans to the left politically, I tend to favor more rather than less regulation of financial markets to ensure protection of investors, who often rely on others to manage their investments. For those requiring the most security, bonds—which pay a regular, pre-set yield (the reason they’re called fixed income), and are largely less volatile than equities—are typically the safest bet.

However, confidence in the bond markets was shaken by the 2008 credit crunch and ensuing financial crisis, and was especially shaken in fixed-income-specific datasets that arguably should have better predicted the looming catastrophe, such as credit ratings.

Lawsuit
Indeed, the US Department of Justice (DoJ) sued Standard & Poor’s Ratings Services in February, alleging that the agency misled investors about its independence and knowingly issued inflated ratings for mortgage-backed securities and collateralized debt obligations, focusing more on winning deals against Moody’s and Fitch than on ensuring accuracy. At the time, S&P officials called the lawsuit “meritless,” and noted that other agencies issued the same ratings at the same times, suggesting that despite the myriad emails produced by the DoJ, the result was the same for everyone.

Should rating agencies have performed better and shouldered some of the blame? Absolutely. But should they shoulder it alone? Those with a fiduciary responsibility cannot offload that to a third party.

Then, after coming under fire for not providing sufficiently accurate information to investors in the run-up to the credit crunch and financial crisis, the agencies came under further fire from governments for downgrading already-fragile sovereign debt.

The EC’s plans impose stricter rules to limit the influence that corporations can exert on their own ratings … yet arguably do the opposite in the case of sovereign ratings.

The European Commission—the governing body of the European Union, whose members issued much of that fragile debt—implemented stricter rules in June to make CRAs more accountable, while at the same time reducing their influence over investors.

Limited Influence
The EC’s plans also impose stricter rules to limit the influence that corporations can exert on their own ratings—specifically, by reducing conflicts of interest that arise from the issuer-pays model, including forcing companies to rotate agencies every four years*, and by imposing limits on how big a stake a company may own in rating agencies—yet arguably do the opposite in the case of sovereign ratings, by limiting the number of unsolicited ratings that can be issued on a country to three per year, whereas one might argue that a real-time ratings framework would do more to aid transparency and smooth the impact of changes.

The EC says the reason for wanting to make agencies “more accountable for their actions” is that “ratings are not just simple opinions.” But in fact, that’s exactly what they are, and the “quasi-institutional role” that makes them more than “just simple opinions” is assigned to them by governments and their regulators. Anyone who issues a “buy, sell or hold” recommendation on a stock or bond is essentially fulfilling a similar role. And if their decision is based on careful analysis of the same data available to rating agencies—and even more detailed factors now available, including forensic accounting—rather than just subjective opinion, should their opinion be any less or more valid? If regulators feel agencies are inaccurate, outdated, biased and falling short of their mandate, remove the mandate: Make ratings just another optional dataset that firms can choose to subscribe to or not.

The data and technology are available for firms to seek out different sources of ratings—including providers outside the top three—and similar services to synthesize their own ratings datasets that don’t just meet compliance requirements, but can also add competitive value, and create more competition between rating agencies. And the EC’s new rules—though establishing a framework for including ratings data—include provisions for firms to “strengthen their own credit risk assessment” while reducing their reliance on ratings. This creates great opportunities for agencies and their clients to rethink how they create and use ratings, and ultimately get more value from them.

*Author's note: As our friends at S&P point out, this rotation rule only applies to re-securitizatons, such as CDOs.