Credit rating agencies face criticism and regulation

Posted on : Sun, 27 Nov 2011

Credit rating agencies have been facing strong criticism for failing to predict the risk of the financial turmoil of recent years, and for playing a role in sparking and exacerbating it. The EU has just unveiled draft proposals to step up regulation of these agencies, and the US passed its own measures last year. Some of the criticisms are fair but, according to QNB Capital, there is a danger of focusing blame on the agencies, and ignoring wider responsibility.

The ratings sector is dominated by three agencies: Moody’s, Standard & Poor’s and Fitch. Their ratings, ranging from AAA down to D, are intended to provide investors with a measure of the risk that a borrower will default on debt payments. Investors had confidence in the ratings because of decades-long track records show that, for example, less than 1% of the bonds granted a AAA-rating subsequently defaulted.
Their assessments were so highly regarded that governments even utilised them in regulations. Certain investors, such as pension funds, were restricted from holding risky bonds with ratings below BBB- (called “junk bonds”).

However, the agencies have made a series of misjudgements, and the rare “black swan” event of the global financial crisis has seriously marred their ratings track record.

In 2004-07 they rated tens of thousands of mortgage-backed securities (MBSs), created by banks pooling together large numbers of individual mortgages. The ratings models used assumed that house prices would continue rising, and hence that there was little risk of large numbers of mortgages defaulting simultaneously. As a result, they gave AAA-ratings to many MBSs, driving a strong demand for these supposedly safe investments, keeping mortgage rates low and feeding the housing bubble. In the process, they made record profits from the fees paid by the banks issuing MBSs.

When the housing market turned in late 2006 and defaults began rising, particularly in the subprime segment, the agencies nonetheless continued to rate MBSs highly. Then suddenly, in July 2007, they sharply downgraded thousands of MBSs. These downgrades forced many institutional investors to sell their MBSs, because of the legal prohibitions on junk-bonds.

This was arguably the start of the crisis which, due to loss of confidence in the credit and interbank markets, ultimately led to the collapse of Lehman Brothers and sparked a global recession. In its aftermath, the 2010 Dodd-Frank Act required that all reliance on ratings be removed from US regulations, and that the agencies become more transparent.

However, the US Congress decided against introducing measures to address the potential conflict of interest resulting from the agencies charging debt issuers for their ratings. Some observers argue that financial incentives to please issuers contributed to their poor judgement on MBSs. The agencies, however, insist that their internal controls and the importance of their reputations mitigates this conflict.

The financial crisis and recession led to a sharp increase in the deficits and debt of many developed countries, throwing doubts on their longstanding high credit ratings. In the case of Greece and other troubled Eurozone countries investors have demanded higher yields for their debt. This has gone hand-in-hand with downgrades of the debt by rating agencies, which causes investors to demand yet higher yields, making the debt more expensive to refinance and so less sustainable.

This has frustrated the Eurozone borrowers, but it is not clear that the rating agencies are at fault—if anything they were too slow with their downgrades.

The European Commission’s Michel Barnier responded on 15th November 2011 with a set of proposals to regulate rating agencies. Some of these proposals, such as the creation of a composite ratings index and a requirement for issuers to periodically rotate the agencies they pay for ratings, could be productive and boost competition in the sector. Mr Barnier backpeddled on a more controversial proposal that would enable the EU to force agencies to “suspend” the ratings of countries undergoing bailouts, like Greece. Nonetheless, this proposal is still under consideration.

Despite a loss of prestige and an increase in their regulation, QNB Capital argues that the ratings agencies will continue to play an important role. This is because market measures of credit risk, such as yield spreads and credit default swaps, could not adequately replace ratings for investors.

These alternatives are prone to short-term demand-driven movements that are not necessarily related to the underlying risk of the debt. For example, yields on US treasuries have decreased in recent months as a safe-haven investment, even as political deadlock has undermined US efforts to get to grips with its deficit, increasing the real default risk.

Ratings agencies were not alone in failing to predict the crises. Although their focus on credit risk should have encouraged more caution, other key players in the financial system—banks, investors and regulators—also failed. The lesson for the future is not to abandon ratings, but to refine the process and methodology. Also, investors should give more weight to other risk measures.