The proposed Basel capital adequacy accord will likely close a loophole that allows structurers and investors to arbitrage rating agencies in order to get a desired rating for collateralized debt obligations. Rating agencies assign different ratings for the same obligations because their methodologies and projected default curves are different. Investors and structurers are aware of this and frequently ask Moody's Investors Service to rate the lower tranches of a deal and Standard & Poor's or Fitch Ratings to rate the higher tranches.
"For AAA notes Moody's is the harshest, but for mezzanine classes S&P tends to be the harshest," according to Yukio Egawa, director in the global securitization research group at Deutsche Securities in Tokyo. Officials at Moody's and S&P declined comment on this point.
The Basel Committee on Banking Supervision published a guidance paper last week which stated, "a bank cannot use one institution's credit assessments for one or more tranches and another credit assessment for other positions (whether retained or purchased) within the same securitization structure that may or may not be rated by the first agency." If this comes in to force it will put an end to CDOs that have the lower tranches rated by Moody's and the senior tranches rated by S&P.
The difference stems from Moody's calculating the expected loss of a transaction, how much money the investor will lose, while the other rating agencies calculate the probability of a default and the likelihood of the investors suffering any loss.
Cliff Griep, chief credit officer at S&P in New York, said the proposed capital accord will incorporate ratings to regulatory capital calculations and therefore it is important banks cannot cherry pick ratings. However, Klaus Toft, head of credit derivatives sales strategies at Goldman Sachs in London, said it is good to have different methodologies. "In modeling there is always a risk that one method might not capture everything."