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.
JCR.co.jp 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.