Friday, September 18, 2009

Rating agencies under fire

The rating agencies are now taking hits from every direction. The Big Three are becoming increasingly focused on trying to defend themselves against law suits, investigations, and pending regulation. The most critical blow recently came from the highly publicized case involving Cheyne Finance. This was an SIV that issued medium term notes which were rated "investment grade" by the agencies. The notes defaulted recently and the holders took the agencies (as well as Morgan Stanley) to court.

Dow Jones: Two credit-rating agencies must defend a lawsuit over the collapse of a $5.86 billion structured investment vehicle in 2007, a federal judge has ruled, rejecting an argument that their ratings are protected free speech.

In an order Wednesday, U.S. District Judge Shira Scheindlin in Manhattan rejected an argument by rating firms Moody's Investors Service and Standard & Poor's that their ratings of SIV Portfolio PLC were protected by the First Amendment.

The rating agencies' traditional defense had always been the "freedom of speech" concept. The argument is that the ratings they issue are simply their opinion and therefore should be protected under the US constitution. This case however shook things up because the judge ruled otherwise (at least in a couple of specific instances). With evidence like this IM exchange between two S&P employees, it's a bit difficult to argue freedom of speech.

source: CNBC

The agencies are confident they will be able to overturn this ruling, but nevertheless this may set a precedent and open a floodgate of litigation.

But the Big Three's problems are not limited to investor lawsuits. As people begin to fully appreciate their role in the financial crisis, more players are coming out of the woodwork to start investigations, file complaints, or propose regulation. Now the California Attorney General is jumping on the bandwagon.

Reuters: California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor's, Moody's Investors Service, and Fitch Ratings as he launched an investigation of whether they broke state law with the ratings they provided mortgage-backed securities.

The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition.

The insurance industry is also getting ready to pound on the rating agencies.
NAIC: The National Association of Insurance Commissioners (NAIC) will hold a public hearing on September 24 to discuss the past and future roles of Nationally Recognized Statistical Ratings Organizations (NRSRO). The hearing will examine the role of these credit rating agencies in the insurance regulatory system and what changes may be needed in light of the financial crisis.

Insurance companies hold nearly $3 trillion in rated bonds and the insurance industry constitutes the largest sector of the financial services industry to rely on credit ratings to supervise capital asset adequacy. Insurance regulators currently mandate the use of credit ratings to determine capital reserves and other regulatory requirements for insurance companies.

And here comes the SEC with what seems to be a fairly constructive disclosure rule that may cause the agencies and banks some pain:

Reuters: The SEC may require banks and other issuers to disclose preliminary ratings, to prevent them from shopping around for the better ratings, the people familiar said. They requested anonymity because the discussions are private.

The SEC may also require all credit agencies to reveal more information about past ratings so investors could compare their relative performance, with perhaps a one- or two-year time lag, the people said.

The structural problem with the rating agencies and their role in the crisis is finally getting the much needed attention. Here is a simple fact: if the rating agencies' subordination requirement for AAA subprime paper was higher when the deals were rated, the subprime market would never have grown the way it did. A typical subprime deal had 21% of collateral below AAA, while Alt-A subordination was about 7%. If the rating agencies were just a bit more conservative, requiring a higher cushion, the mortgage rates for these loans would have been much higher to make the securitization work. And that simply means most such mortgages would not have been possible.

The question is where do we go from here. Securities ratings process is so entrenched in the financial services industry, it's hard to imagine the system functioning without some form of ratings. It's part of the lexicon: when we discuss "investment grade" market or the "high yield" market, there is an implied rating assumption - whether people use it or not. The lesson of 2008 was of course to rely less on the agencies, but the system depends on them being there. And the government is doing a great deal to increase (rather than reduce) reliance on the ratings process: from new money market regulation to TALF - all depend on some form of agency ratings.

That means that the rating agencies are here to stay, and when the dust settles, the surviving agencies (and it's not clear if all of the Big Three will survive) will have a great deal of work to do. It's critical that we fix the ratings system: from agencies' internal structure to the ratings process to models and transparency to fees/conflicts - all must be revamped in order for the system to function properly. Because not getting this right will set us up for another fiasco down the road.

Related Posts Plugin for WordPress, Blogger...
Bookmark this post:
Share on StockTwits