By Philip Alexander and Taimur Ahmad
By late 2006, the three leading credit rating agencies each issued warnings about a significant deterioration in the 2005-06 cohort of sub-prime mortgages. Yet it wasn’t until July 2007 onwards that many actual downgrades of the mortgage-back securities and the collateralized debt obligations (CDOs) that referenced them actually took place. By then, several major hedge funds exposed to the asset class had already collapsed, and weeks of market turmoil ensued.
The “issuer pays” business model of credit ratings has been in place for almost half a century, and has allowed the agencies to access confidential issuer information not distributed to the wider market. But the cries of conflict of interest have never been louder than today, as both the US Senate Banking Committee and House Financial Services Committee have launched hearings on the agencies’ culpability.
The market, the legislators and the agencies themselves are now working out the implications of all this for the financial services industry. Emerging Markets asks the key players for their views.
The competitor
“What do credit ratings actually mean?” asks Donald van Deventer, CEO of Kamakura Corporation, the credit risk management advisory company he founded in 1990. It is not a rhetorical question. One agency defines a CCC credit as having an average default risk of 27% over the first year. “Over the past 25 years, the actual default rate over one year for CCC credits has varied from zero at the top of the cycle, to as much as 44% at the bottom. It seems so much more precise to us to say, if you want to know the one-year or five-year default risk for this company, then here it is,” van Deventer tells Emerging Markets.
Kamakura now publishes “off-the-peg” default probabilities over set time horizons for 19,000 companies in 29 countries, updated daily. The firm has similar ready-made ratings for some synthetic CDOs, while helping build bespoke models for more complex cash flow deals. Van Deventer has been working with clients who realize their reliance on credit ratings to map portfolio risk is inadequate, as valuations of some illiquid CDOs have halved without ratings actions of similar severity. “Of course, some of these institutional investors should have come to us much sooner, or should have stayed away from instruments they couldn’t value.”
He believes the “issuer pays” model might have been appropriate when the agencies were newly created and did not have a track record to demonstrate the accuracy of their ratings. Today, with the agencies so deeply established, this argument no longer holds true. Instead, as issuer fees – especially in structured finance – are so central to the big three companies’ revenues, van Deventer warns that there is a clear incentive at a senior level to steer clear of new methodologies that could lead to wide swathes of lower ratings across the whole structured asset class.
It is too soon to know yet whether actual default rates on CDOs will show the credit rating agencies to have been overly rosy in their assessments. But already during the current crisis, says van Deventer, there have been downgrades as extreme as from AAA to CCC almost overnight, casting serious doubt on the quality of the original ratings.
There is, of course, more to default risk than financial data – especially in the historically less stable operating environments of emerging markets. The agencies emphasize the use of qualitative factors such as company strategy, corporate governance and legal or political risks in reaching an overall rating. This cannot always be included in his “off-the-peg” ratings, van Deventer acknowledges, but Kamakura allows clients to buy the models and helps customize them to introduce such risks. He argues that this creates full transparency, whereas the ratings agencies do not disclose the qualitative scores that feed into the headline ratings.
The seller
For now, investment bank arrangers still need their products rated by the agencies, and are therefore understandably reluctant to comment on the record. But one head of European CDO syndication was willing to tell Emerging Markets that he had concerns about some recent events in the asset-backed security (ABS) market in particular. “You have seen quite highly rated bonds migrate very quickly down the ratings spectrum. That is the market that is least likely to be viable again any time soon.” However, he does not necessarily observe a breakdown in trust in the ratings themselves. “It is more that people don’t trust the underlying market; they think it is credit-impaired, that there are real losses there.”
He argues that AAA rated ABS CDOs were stress-tested to many times the historical default and liquidity disruption levels. The problem is that, by its nature, the structured products market is about more than just credit risk: the structures themselves are crucial to valuations. The banker points out that yields on CDOs rated AAA could vary by as much as 100 basis points. “Everyone has got to be aware that there is a relativity to triple-A ratings. The market is very efficient at pricing risk; you don’t get paid for nothing; so I only have so much sympathy with investors blaming the agencies.”
One of his concerns is that, with a limited pool of talent available, ratings agency staff are quickly drawn into the banking sector. “They do struggle to recruit staff. It can lead to backlogs and extra pressure on the ratings process, and lack of expertise.” But he adds that attention should not just focus on structured ratings teams. “If there is an issue, it is that they didn’t pick up on the speed with which the underlying ABS collateral deteriorated. In that case, you are not looking at the structured team, but at their colleagues in the bank rating teams who should be watching fundamental developments in the mortgage market.”
The buyer
“We don’t really rely on credit ratings to the extent that we say, if it’s a triple-B rating, it should have certain risk losses,” says Jeroen Bakker, a managing partner at structured products investor Faxtor Securities in Amsterdam. “For us it is the other way around: we run our own analysis, and based on that, we decide whether or not to invest in the transaction.”
The ratings agencies themselves emphasize their research is not a recommendation to buy or sell the assets. If so, what’s the point of ratings? Bakker acknowledges they are partly used purely for compliance, with regulated investors required to show the ratings breakdown of their portfolio. In addition, CDO tranches are structured to reference a basket of securities with a given weighted average rating – although this process is itself based around the methodology of the agencies.
Given the latter use of ratings, Bakker echoes sell-side concerns about multi-notch downgrades of ABS securities in mid-2007. He points out that, if fundamental developments in US sub-prime markets were to blame for putting certain securities under pressure, “you would expect the rating deterioration to be a more gradual move, because these problems have not appeared overnight.” Instead, he notes, the agencies seem to have revised their models drastically at one stage, leading to a sudden wave of downgrades.
Still, Bakker believes it is too late for investors to start complaining that agencies were given confidential information on underlying assets in CDO pools that was not made publicly available. “We have always asked for that information; we generally get it; and if we don’t, then we can always decide not to invest,” he says.
The lawmaker
In recent weeks the credit rating industry has faced severe scrutiny by congressional lawmakers about companies’ relationships with issuers. Credit rating agencies have been accused of conducting weak analyses and granting higher ratings because they are paid by the companies whose securities they rate.
The widespread view is that ultimately something must be done to resolve the problem of a market that is forced to reply upon ratings firms that are only paid to rate securities, not downgrade them. But conflict of interest is only part of the issue.
For Barney Frank, chairman of the House Financial Service Committee, which is overseeing the hearings into the industry, the real question is about information and disclosure. In the latest crisis, he tells Emerging Markets, “Ratings agencies turned out to be damaging because they told us more than they know. And there is this issue – and it’s very much an international one – that what we need now is to get more information.”
At the outset, he says, it’s a transparency issue. “Maybe it goes beyond that, but that’s what you’ve got to start with,” he says. “There’s a reason to believe that people don’t know enough to make rational decisions, and we have to figure out what we can do to get more information.”
Though he doesn’t believe the agencies lied, he nevertheless believes they got it wrong. “They said these things were triple AAA when they obviously shouldn’t have been,” he said last month.
Ratings, says Frank, should never be a substitute for regulation. “If people want to rely on credit ratings from the agencies, that’s their choice, but it shouldn’t be as if it were the main protection for people – that’s inappropriate: they’re private entities.
“Many people are saying ‘you don’t need more regulation; you’ve got credit ratings agencies.’ Well, that’s clearly not true,” he adds.
The agencies
For the credit ratings agencies, reputation is everything, insists Barbara Ridpath, executive managing director of European rating services at Standard & Poor’s. For this reason, the company publishes all its methodologies and a code of conduct for all employees that explicitly seeks to avoid issuers unduly influencing the ratings process. Moreover, the issuer fee allows free distribution of the ratings themselves, boosting market transparency.
“Every banker likes to tell their client they pushed the agency to get a better rating; that’s their marketing tool,” says Ridpath, who has also worked on the other side of the fence for JP Morgan. “But in reality, our criteria are publicly available, non-negotiable and consistently applied. We could not give special treatment to one issuer without the whole market seeing it and demanding the same.”
Both Ridpath and Richard Hunter, chief credit officer for Europe at Fitch Ratings, emphasize the unprecedented nature of fundamental events in the 2006 cohort of sub-prime mortgages. “The loss experience has doubled from 2005, which is more or less unheard of across all structured finance asset classes,” Hunter tells Emerging Markets.
And while underlying collateral has deteriorated rapidly, actual defaults on the rated sub-prime mortgage-backed securities themselves are still very rare – only a handful out of 15,000 rated by S&P at end-August 2007. In fact, S&P calculates rolling five-year default rates for speculative grade structured credits since 1978 at just over 15%, compared with 20% for corporate credits. This suggests that, if anything, structured finance ratings have been comparatively conservative.
As a result, the disruption in the market stemmed from a repricing of default risk and collapse of risk appetite, not a surge in structured finance defaults. Regulators and central banks have encouraged the agencies to keep the ratings focused on default, says Hunter, rather than incorporating elements such as liquidity, price stability and loss given default, which could obscure market understanding of the ratings.
Similarly, assigning more stable “through the cycle” ratings rather than changeable default probabilities facilitates comparisons between issuers.
In response to alarm about what happened in mid-2007, both agencies are seeking to build separate products that can help investors to assess liquidity risk and value complex structured products more accurately, without confusing the purpose of credit ratings themselves.
Hunter acknowledges that some of the downgrades of asset-backed securities have been sharp. “There is no downgrade action that we would not rather have taken the day before. But of the $173 billion in 2006 sub-prime-backed securities that we began looking at early this year, in the end we have only downgraded $18 billion.” Hence, he argues, taking the time and awaiting the data to distinguish only those tranches that were becoming severely impaired was less disruptive than “putting the whole $173 billion on negative credit watch and then ultimately affirming the other $155 billion”.
Similarly, Ridpath says high staff turnover when the economy is strong puts the agency under pressure. However, retention at a senior level is good, and S&P makes use of this experience through the ratings committees, to ensure the arranger’s view of their own product is rigorously examined. “On every committee, there will always be at least one highly experienced manager who can challenge assumptions about the transaction structure.”