Thursday, June 24, 2010

The Future of Credit Rating Agencies

By: BPP Business School (Edward Bace)

The big global credit rating agencies (or CRAs, ie S&P, Moody's,
Fitch) originated in America a century ago to help investors
evaluate creditworthiness of bonds, issued by entities from
railways to governments to industrial firms. Over time CRAs grew
internationally, now assessing all kinds of debt. They have
enhanced transparency around a broad credit spectrum. Their
contribution to market discipline has been positive overall,
giving basis to sound credit pricing using default statistics
dating back decades.

With proliferating exotic instruments, securitizations and
manifold debt classes, CRAs have continued investor education.
Yet in recent years they've been swept up with investors in new
product momentum (and generous rating fees). In assigning top
ratings to structured products, particularly in US residential
mortgages, critical analysis was lacking; many deals originally
accorded highest creditworthiness fell drastically, to the
credit spectrum's bottom. A March Moody's study shows that 41%
of structured deals rated Aaa in 2007, and 39% in 2006, fell to
Caa by end-2009 (12 notch drop!). Before 2005, this figure was
1%. Moody's corporates experienced 2-notch average downgrades
over the last decade, versus 7.3 for structured in 2009.1 The
credit crisis should have affected all rating classes similarly;
CRAs seek consistency across sectors. This clearly shows flaws
in structured ratings, provoking international outcry during the

Criticism also stems from profits oligopolistic CRAs enjoy,
enhanced by increased debt issuance volume. Moody's 2007 ratings
profit margin (ebitda before restructuring) was 59%. Close to
half that year's revenue came from structured products.

CRAs first responded with self-regulation, appointing dedicated
compliance personnel, enhancing transparency, and rotating
analysts. In 2004, after failures of Enron and Parmalat
(carrying investment grade ratings - implying low default risk -
just before they went bust), CRAs began conforming to IOSCO's
Code, a voluntary regime built around International Organization
of Securities Commissions standards. This hasn't precluded
tighter regulation, in America and Europe. Last year the EU
approved European Regulation on Credit Rating Agencies, to set
CRA standards, improve transparency and governance, and
introduce regulation and supervision.2 America's financial
reform bill includes a new rating board, regulating CRA
interaction with rating clients.3

This legislation is not a cure-all. CRAs don't have to conduct
diligence on complex securitizations they rate, in contrast to
rating corporates. Since the US bill does require structured
methodology disclosure, which lacked transparency, this should
reduce CRAs' reliance on mathematical models (largely developed
by intermediaries). Excessive confidence in statistical analysis
accompanied insufficient acknowledgement of its limitations.
Direct contact of credit analysts with issuers in structuring
products also represented a conflict.

A fundamental anomaly remains: CRAs earn most of their income
from rated borrowers, not investors. CRAs' market share
ambitions result in incentives for issuers and intermediaries to
"shop" for high ratings. In my investment banking experience,
one public rating usually sufficed for an issue, which naturally
was the highest.

The debate has become more political, as sovereign downgrades
(eg, Greece) have led policy-makers to question CRA power,
including more calls for regulation and a "European" rating
agency. Value of the latter could be dubious, based on Japan's
experience, where JCR, a domestic agency, consistently awards
high ratings to domestic borrowers that global CRAs rate much
lower. For example, JCR rates Bridgestone AA, which Moody's
rates A3, 4 notches lower. JCR's extensive corporate ratings
list reveals just 2 sub-investment-grade firms, aside from
defaulted issuers (like JAL).4

Following are proposals to limit potential negative CRA

Regulated and sophisticated investors should rely more on own

Market participants should reduce ratings reliance in investment

CRAs should make available further information free to access.

Effective self-regulation is preferable to government
regulation, offering greater flexibility, expertise, acceptance,
higher standards, and more competition.

Above all, investors' interests should come first.


1. Tung, J. and Weill, N. (2010), "Structured Finance Rating
Transitions: 1983-2009," Moody's Investors Service: 9. 2.
Parker, E. and Bake, M. (2009), "Regulation of Credit Rating
Agencies in Europe," Butterworths Journal of International
Banking and Financial Law: 401-403. 3. Dodd, C., Chairman
(2010), "Summary: Restoring American Financial Stability,"
Senate Committee on Banking, Housing and Urban Affairs: 8. 4. website. 5. Pizzani, L. (2008), "(Dis)Credit Ratings,"
CFA Magazine: 14-15.

About the author:
This article was written by Edward Bace a lecturer at BPP
Business School London.

BPP Business School is a leading provider of postgraduate
education with an excellent range of courses including the
MSc Finance and MSc Management degrees.

Tuesday, June 22, 2010

21 Reasons The Economy Is About To Crash

1) Easy Money was the chosen solution to keep the good times
rolling, even though the good times were questionable.

2) Productivity was already being impacted by poor allocation of
resources, wars not going well.

3) Financial oligarchs effectively took over the government,
existing laws were not enforced, and as thing came to a head in
2006 and 2007 the big brokers (deal makers, IPO, LBO's) were
hiring specialists in bankruptcy reorganization. They were
poised to buy stuff up on the cheap when things blew up.

4) The recent "recovery" is really just the same recession, but
given a hit of crack so it can party on a little longer. Many
trillions were spent, but it mostly benefiting big business, big
banks/brokers. Long term benefits to the economy are

5) Government workers have increased their pay like 30% to 40%
whilst non-gov workers have treaded water, even if they have a
job at all.

6) Government is expanding it's powers and owning businesses.
Whilst theoretically, expanded powers could be useful, why we
anyone assume so, given that existing laws and oversight were
already so poorly performed.

7) Lobbying, campaign contributions, and restrictions on how any
Gov official could migrate from an oversight of an industry to
an executive or lobbying position must be instituted.

8) Deflation is likely to be the near term hobgoblin.

9) The Gov can literally just print money, seriously. They can
hand out that paper money to pay off debts. They do not have to
roll over every debt. All the governments with soveriegn
currencies can do this. The Euro cannot. This is called
competitive devaluation.

10) Inflation can take hold someday. You best not have all your
assets in paper money or equivalents. These changes may happen
relatively quickly, like by 2012.

11) The US has plenty of military muscle, expect it to be used
more, especially as things go bad.

12) If anyone owes you money, get it now.

13) Very few, maybe 1% of the population learned anything from
the greatest financial crisis in a century. Or they "learned"
that the Gov can indeed save us by strong Gov intervention in
free markets. This makes the next crisis more dangerous.

14) Very few of the problems of the crisis were solved by those
trillions of dollars thrown at the situation. It was more just a
transfer of wealth from a captive audience to the ogliarchs. The
bad debts, bad assets are still on the books, they have just
been covered up. Those in the know, know it, and they are
pulling out all the stops to "get theirs" before round 2.

14) There may be a QE2 (Quantitative Easing, money printing,
throwing money at large banks/brokers), or the USA could follow
the austerity trend that is all the rage (pun intended).

15) Reviewed Conquer the Crash by Big Daddy Pretcher. We all
love Pretcher, he is a free thinker, like Armstrong, but he has
been so wrong for so long, he is not infalliable. His view on
Gold is wrong, it is not just a commodity that reacts like

16) Gold is a currency. Paper gold is a speculation device,
owning gold ETFs and even gold miners is not the same as owning
physical gold. Silver is good for making change, buying a tank
of gas, bag of rice, etc.

17) We are not at the precipice of Primary 3 wave down, we could
be near the end of the 1st 5 waves down (completion of wave 1).
Wave 2 could slog sideways for years, like a zombie propped up
by QE2.

18) Most people have lived beyond their means for a long time.
Most "young people" say 35 and younger, have only lived in a
bull market.

19) In order for any chance of moving forward with positive
results a few things must happen--banks and investment
advisers/brokers/deal makers must be separated by a firewall,
not a just a company division name, lobbying must be curtailed,
contract law including making bondholders take their lumps, must
be restored.

20) Never has the world been so intertwined. Never has the
situation for competitive devaluation of every countries
currency been so nicely setup.

21) There is still something like $600T of notional value of
derivatives floating around out there, and apparently no one
even knows where they are or how to track them. This is many
multiples of the world GDP. This can't be good for the common

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