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Home > Blogs > Ian Fraser > It's time investors saw sense and stopped giving credence to ratings agencies

It's time investors saw sense and stopped giving credence to ratings agencies

CRA | It's time investors saw sense and stopped giving credence to ratings agencies Ian Fraser

The credit rating agencies performed so woefully in the run-up to the global financial crisis, one might have thought they would be utterly discredited by now.

One of the agencies biggest and most costly mistakes was their rampant mislabeling residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) in 2004-07. At the time, they had few qualms about assisting clients who wanted to give AAA, "safe as houses" status to what was in reality un-repayable debt. Then with their (delayed) mass downgrading of much of this toxic debt from July 2007 onwards, the credit rating agencies played a massive part in stoking up the global financial crisis.

Controversy and CRAs

In April 2011 the Senate Permanent Subcommittee on Investigations produced compelling evidence of wrongdoing in the sector.  In a report titled "Wall Street and the Financial Crisis - Anatomy of a Financial Collapse” it revealed that executives in the ‘big three’ agencies -- Standard & Poor's, Moody's and Fitch -- were aware that many of the CDOs and RMBS to which their firms accorded 'AAA' status were in reality 'BBB'.

It seems that they chose to mislabel the securities out of fear of upsetting clients (big banks such as UBS) and/or losing fees to more compliant rivals. If there's a clearer evidence of a broken financial system, I don't know what it is (the Senate report findings are explored in greater detail by Katya Wachel in Business Insider).

Despite their protestations to the contrary, the performance of credit-rating agencies performance in the field of sovereign debt is no less woeful. As Andrew Clark wrote in The Observer on April 24:-

“On the international front, Ireland commanded a triple-A rating from S&P until March 2009 and was rated double-A until November 2010 – the month the country appealed to the European Union for a bailout. Iceland, Portugal and Greece were marked down a little bit earlier…"

Given all this background, why isn't the research and ratings that they produce devalued, why aren't they increasingly cold-shouldered and ignored by the market, and why haven't some of their bosses been held accountable?

It is partially because investors prefer to stick with the 'devil they know'; particularly in the fixed income market, they have become so accustomed to outsourcing risk-management and due diligence to the CRAs, it is hard to break the habit. Another is that governments are loath to be too harsh on the rating agencies since to so would leave them wide open to charges of hypocrisy -- governments too are dependent on the rating agencies to evaluate, and dare I say it, to promote, their own sovereign debt.

Catching up with the markets

So why am I writing about this now? Well, Moody's New York-based Investor Services has been hyperactive of late. And, as with its post hoc rationalization of subprime-linked debt during the 2007 credit crunch, it seems to be playing catch up with market realities.

In recent weeks the New York-based company has put America on notice, warning that the US’s debt is at risk of being downgraded; saying there's a 50% chance of a Greek sovereign default by 2015; and telling us that UK and US banks are at risk of a downgrade because of the unlikelihood that their governments will be prepared to fund any further bailouts.

These moves only served to increase the venom directed at CRAs. While some commentators, such as Ron DeLegge in ETF Guide suggested that the lack of market reaction to the US news meant the influence of rating agencies is on the wane, others are less sure of that.

Embedded in the system

In a speech on May 23, Paul Tucker, deputy governor of the Bank of England, argued they are still firmly embedded in the global financial system. He said that weaning investors off their reliance on the ratings remains one of the toughest challenges that financial reformers face.

"Pervasive mechanistic reliance on ratings is by no means mainly the fault of the rating agencies themselves or of financial firms, although many of the latter have acted – and probably continue to act – foolishly.  The extent to which ratings have been bolted into regulatory regimes – by securities regulators and prudential supervisors – has plainly been a great mistake. And it is one of those mistakes whose effects have become so woven into the fabric of ‘modern’ finance that it is going to take an extraordinary act of will (and patience) to undo it."

The rating agencies stranglehold of the market is increasingly under threat -- the arrival of new more transparent players such as Dagong Global Rating Rating Co is helping here --- and their ill-deserved reputation for omniscience is increasingly being chipped away. However, even though something of a regulatory blitz is also underway, it remains to be seen if any government or regulator anywhere in the world has the stomach to drive through real change in the sector.

Further reading on the challenges facing credit rating agencies:




Tags: CDO , collateralized debt obligation , CRA , CRAs , credit rating agencies , financial crisis , Fitch , global financial crisis , Moody's , residential mortgage , RMBS , sovereign debt , sovereign debt crisis , Standard & Poor's
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