Pointing the finger

As the fall-out from the credit market crisis continues, Scott Payton discovers who is attracting criticism in the latest chapter of the 'blame game'

Credit rating agencies' role in life is to gauge the creditworthiness of organisations issuing debt instruments, such as corporate and government bonds. Investors, banks, regulators and other market operators rely on the agencies' ratings to measure relative credit risk. Credit rating agencies are, therefore, crucial 'gatekeepers' in the credit markets: billions of dollars-worth of debt is issued and borrowed based on their analysis.

As well as rating traditional bonds, credit rating agencies also offer advice on structured financial products, such as collateralised debt obligations (CDOs). It is here that the agencies have found themselves at the sharp end of some difficult recent questions.

CDOs are complex portfolios of fixed-income assets. They are divided into 'tranches', with each tranche containing assets holding a different level of credit risk. Credit rating agencies have played a key role in helping those structuring CDOs to assign the appropriate levels of risk to each tranche.

CDOs skyrocketed in popularity in recent years, with sales of collateralised debt instruments reaching US$503bn in 2006 - five times higher than in 2004, according to investment bank Morgan Stanley. Unfortunately for investors, many CDOs included sub-prime mortgage bonds within their complex tranches - with catastrophic results.

Take one US$340.7m CDO issued by Credit Suisse Group in December 2000. Eighty-five percent of the CDO's tranches received the top AAA or Aaa rating by the big three credit rating agencies - Standard & Poor's (S&P), Fitch Ratings and Moody's Investors Service. Indeed, 95% of the CDO received an 'investment grade' rating. However, the other 5% of the CDO included far riskier sub-prime mortgage bonds. Defaults in sub-prime mortgages mounted over the six years following December 2000, contributing to a total loss of around US$125m for the Credit Suisse CDO by the end of 2006.

By the second half of 2007, it became clear that CDO losses were a widespread problem. In October, Merrill Lynch reported US$7.9bn of third-quarter write-downs related to CDOs. By November, total bank CDO-related losses had reached at least US$38bn, with analysts at JP Morgan Chase & Co predicting this to grow to US$77bn.

The question is: to what extent - if at all - are credit rating agencies to blame?

Attacks on rating agencies focus on two charges:

• agencies receive fees from organisations issuing debt and constructing CDOs. This, critics argue, makes them unable to provide objective information about the risks associated with investing in these debt instruments
• credit rating agencies' methods of rating and categorising CDOs do not make it easy enough for investors to see the true levels of risks they carry. 'The triple-A ratings assigned by credit rating agencies would have led some investors to believe that these complex debt structures were bomb-proof. And, as we've seen, that's not the case,' says Fenton Burgin, a partner in Deloitte's debt advisory practice.

Cautious

Robin Menzel, a partner at merchant bank Augusta and Co with 19 years' experience in the leveraged debt markets, is generally cautious about joining the rating agency witch-hunt. 'Every time investors lose money, they look to blame somebody,' he says. 'This time the agencies got hit because there's no-one else to blame; there's no Enron, for example.'

Menzel also points out that rating agencies perform a 'short-hand function' in the financial markets. 'You can choose to take their letters or you can choose to do [your own] homework. And some of the more lazy [investors] have chosen to rely on the agencies' letters,' he says.

However, Menzel concedes that when it comes to the role of rating agencies in helping to design the same CDOs that they rate, there is legitimate cause for concern. 'The rating agencies get paid by the borrowers to rate their structures. It is open to conflict - as is the fundamental rating agency model,' he says.

The only way to guard against this conflict of interest is to increase competition in the rating agency industry, says Menzel. He adds that potential conflicts of interest are also inherent in the investment-banking model, but that they are mitigated by healthy competition. Yet in the rating agency world, competition is limited. Indeed, the US Securities and Exchange Commission (SEC) has only approved three agencies - Moody's, Fitch and S&P. 'We've got a triopoly rather than a competitive landscape. The market will demand more agencies. There are already several independent credit research shops doing great work - for instance, Glenn Reynolds' team at CreditSights,' says Menzel.

Others, including US and European political leaders, are calling on the agencies to make their ratings of CDOs clearer and more meaningful to investors, or face tighter regulations. At the end of January, a joint communique issued by Gordon Brown, Nicolas Sarkozy, Angela Merkel, Romano Prodi and European Commission President, Manuel Barroso, called for 'improvements in the information content of credit ratings to increase investors' understanding of the risks associated with structured products'. The EU leaders also said that they were 'ready to consider regulatory alternatives'.

In the US, both the SEC and the presidential Working Group on Financial Markets are investigating potential failures in agencies' ratings of CDOs. New regulations could be introduced by the middle of this year as a result. The SEC is also exploring ways to reduce its own dependence on credit rating agency data. 'SEC chairman, Christopher Cox, has raised his concerns about whether regulators have relied too heavily on the credit rating agencies as proxies for objective standards for monitoring risk,' says Burgin.

Meanwhile, the rating agencies themselves are responding to criticisms by introducing their own reforms and consultations. S&P, for example, said it would implement a raft of changes, including:

• appointing an ombudsman to monitor potential conflicts of interest among its analysts
• regularly rotating analysts between 'beats' to prevent them from developing cosy relationships with those issuing debt instruments
• clearly differentiating between ratings of CDOs and other types of debt, and
• providing analysis of the potential impact of theoretical future scenarios on the instruments that they rate.

'By further enhancing independence, strengthening the ratings process, and increasing transparency, the actions we are taking will serve the public interest by building greater confidence in credit ratings and supporting the efficient operation of the global credit markets,' said Deven Sharma, S&P's President, when announcing the reforms on 7 February.

Moody's and Fitch Ratings have also mooted reforms, including changes to the ways they assign ratings to CDOs.

However, regulators and many others remain unimpressed. 'There is an element of "rather too little, rather too late" in market reactions to the agencies' reforms,' says Burgin.

Andrew Cuomo, New York's Attorney-General, was more scathing, calling the reforms 'more like public relations window dressing than systemic reform', in a statement issued on the day that S&P announced its changes.

The Committee of European Securities Regulators (CESR), the EU's financial watchdog, was also underwhelmed, saying that the rating agencies' proposed reforms were 'not enough'. Like the SEC, the CESR is also considering imposing formal rules on to the currently largely self-regulated agencies.

Menzel, however, does not think new regulations will benefit anyone. 'It's not the solution. It's about getting more voices out there. You can't regulate against conflicts of interests because they exist in the business. All you can do is create transparency and competition.'

Yet Burgin expects regulators to see things differently, and that the days of credit rating agency self-regulation are numbered. 'There is the potential for regulators to over-react,' he says. 'Once the regulatory ball starts to roll, it will be very difficult to stop it.'

Issuers of, and investors in, all types of debt will be watching closely to see just how far this ball rolls.

Scott Payton is a freelance writer and editor.