mortgage meltdown continues to mount, credit rating agencies are
shouldering a hefty chunk of the blame. The penalty they face is
not only harm to their reputation but also intense scrutiny from
regulators determined to eradicate practices they view as
untenable.
The US residential mortgage-backed structured securities fiasco
and its knock-on effect in other debt security sectors could
eventually result in total investment losses of $945 billion,
predicts the International Monetary Fund. A perilous situation for
which a considerable amount of blame is being laid at the doorstep
of the credit rating industry by legislators and regulators on both
sides of the Atlantic.
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Their belligerent stance towards credit rating agencies (CRA) is
not without justification. Intimately involved in what was until
2007 a booming residential mortgage-backed securities (RMBS)
market, CRAs have taken drastic action in the wake of a slumping US
residential property market. There has been a mass downgrading of
RMBS, even for those previously in the highest-rated (AAA)
category.
Though banks have born the brunt of resultant financial losses,
insurers have gone far from unscathed. An estimate made by CRA
Fitch in February this year that total unrealised mark-to-market
losses on subprime and somewhat better quality Alt-A RMBS’ in the
US life insurance industry were between $7 billion and $8 billion
have proved optimistic.
US insurer American International Group alone reported a $9.1
billion pretax charge for net unrealised RMBS market valuation
losses in the first quarter of 2008.
A call for changes
In Europe one of the first major salvos in the direction of the
credit rating industry was fired in March this year by a UK
Treasury select committee chaired by a Member of Parliament, John
McFall.
The committee stressed that the financial crisis that erupted in
August 2007 “highlighted inherent and multiple conflicts of
interest in the credit rating agencies business model as well as
flaws in their rating methods.”
The select committee concluded: “If they [credit rating agencies]
are unable to put their house in order, then new regulation may be
the only answer.
And regulation of CRAs is now the only route to follow, stressed
Charlie McCreevy, the European Union’s Commissioner for Internal
Market and Services in a hard hitting speech delivered at the
Global Financial Services Centre’s inaugural conference held in
Dublin, Ireland on 16 June.
“I said before that I would not wait indefinitely for the credit
rating agencies to come forward with meaningful proposals to put
their houses in order. And I mean what I say,” McCreevy told
conference delegates.
“The IOSCO Code of Conduct to which the rating agencies signed up
has been shown to be a toothless wonder,” he continued.
“The fact is that despite the checks on compliance with the IOSCO
Code, no supervisor appears to have got as much as a sniff of the
rot at the heart of the structured finance rating process before it
all blew up.”
Previous attempts
McCreevy was referring to a voluntary code of conduct for credit
rating agencies introduced in December 2004 by the International
Organisation of Securities Commissions (IOSCO), an organisation
established in 1983 to promote unified international regulatory
standards for securities markets.
Structurally, the code comprises three sections:
• The quality and integrity of the rating process;
• CRA independence and the avoidance of conflicts of interest;
and
• CRA responsibilities to the investing public and issuers.
McCreevy was scornful of attempts being made to enhance the IOSCO
code.
“I am deeply sceptical that the appropriate response lies in
building on and strengthening the IOSCO code,” said McCreevy.
“Many of the recent IOSCO task force recommendations do not appear
enforceable in a meaningful way and I am now convinced that limited
but mandatory, well-targeted and robust internal governance reforms
are going to be imperative to complement stronger external
oversight of rating agencies.”
He continued that while some additional steps the main rating
agencies have announced are welcome, they are insufficient.
“I know some would be willing to do more but I can quite understand
why they are reluctant to move forward with more ambitious
proposals if there isn’t going to be a level playing field,”
stressed McCreevy. “This is one of many reasons why I have
concluded that a regulatory solution at European level is now
necessary.”
Action in the US
While European regulators mull over stricter control of CRAs, their
counterparts in the US have already taken decisive action. The
first landmark development came in on 5 June when the attorney
general of New York Andrew Cuomo announced an agreement on sweeping
changes to the rating methodology of residential mortgage backed
securities (RMBS) to be applied by the three major rating agencies
that have been the most active in the RMBS market: Standard &
Poor’s (S&P) Moody’s Investors Service, and Fitch.
The agreement focused on a key issue under the regulatory
spotlight: a conflict of interests in the CRA industry.
Cuomo explained that a conflict of interest arose because CRAs were
paid no fees during their initial reviews of the residential
mortgage loan pools or during their discussions and negotiations
with investment banks about the structuring of the loan
pools.
“Investment banks were thus able to get free previews of RMBS
assessments from multiple credit rating agencies, enabling the
investment banks to hire the agency that provided the best rating,”
said Cuomo in a statement.
He added that his investigation had also found that CRAs were not
privy to pertinent due diligence information that investment banks
had about the mortgages comprising the loan pools.
SEC proposals
Six days after the New York agreement the Securities and Exchange
Commission (SEC) published proposals for what it termed “a
comprehensive series of credit rating agency reforms.” The
proposals follow the SEC’s authorisation by Congress in September
2007 to oversee nationally recognised statistical rating
organisations.
“The events of recent months have had a profound effect on our
economy and our markets, and they have galvanised regulators and
policy-makers not only in this country but around the world to
re-examine every aspect of the regulatory framework governing
credit rating agencies,” the SEC’s chairman Christopher Cox said in
a statement.
“This package of proposed rules would foster increased
transparency, accountability and competition in the credit rating
agency industry for the benefit of investors.”
In its proposals the SEC has also emphasised conflict of interests
as well as enhanced disclosure of rating methodology. Key aspects
of the SEC’s proposals would:
• End the practice of buying favourable ratings by prohibiting
anyone who participates in determining a credit rating from
negotiating the fee that the issuer pays for it;
• Prohibit CRAs from structuring the same products that they
rate;
• Prohibit a credit rating agency from issuing a rating on a
structured product unless information on assets underlying the
product was available;
• Require disclosure by the rating agencies of the way they rely on
the due diligence of others to verify the assets underlying a
structured product; and
• Require the public disclosure of the information a credit rating
agency uses to determine a rating on a structured product,
including information on the underlying assets.
In addition the SEC has proposed that CRAs differentiate the
ratings they issue on structured products from those they issue on
bonds, either through the use of different symbols or by issuing a
report disclosing the differences between ratings of structured
products and other securities.
Undoubtedly the New York agreement and the SEC’s proposals are
significant steps in the right direction and similar developments
appear likely in Europe and elsewhere.
The real tragedy is that it required a global financial crisis to
trigger regulatory action.
