Vol 9 (2012) - Issue 3

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Why Rate the Raters?

A lot of column inches have been spent dissecting the financial crisis. No small portion of that on the role of the rating agencies. Reporting of the kindest nature talks of naivety and being too ‘malleable’ in their ratings methodology. Less well-meaning reporting puts them as the key piece of the chain of causation relating to the rapid deflation of the credit bubble. Rating agencies are now an easy target for anyone who dislikes the financial circumstances in which they find themselves – a person to blame for their malaise. They have been called to order for being too slow to act, being too fast to act and announcing rating changes inappropriately or even incorrectly. Having spent the first decade of the century providing a service seen by the financial markets as a way to improve the saleability of securities, they are now cast as a problem for the financial markets as a whole. Despite much discussion on the topic, doing away with the rating agencies is not a straightforward option. Their ratings form a key part of asset allocation for any financial institution or asset manager. Ratings are key criteria for determining risk weightings of bank assets, for capital allocation of insurance companies, for the investment criteria of certain pension and endowment funds, for money market funds and much more. Further, the difference between 'investment grade' and 'non-investment grade' (aka 'junk') is the difference between a relatively straightforward debt security with few covenants and a far less straightforward debt security with complicated covenants. High yield bonds (i.e. non-investment grade) and investment grade bonds are largely dealt with separately – bankers who structure or trade high yield bonds, and lawyers who structure and draft the legal position will usually ‘specialise’ in high yield bonds. How did we get to this point? The rating agencies are, it seems to me, a mere reflection of the entire financial industry’s situation. Perhaps not willingly, but you have to suspect that knowingly, they have allowed their ratings to be ‘used’ to help the financial industry fuel the credit expansion. They were established to allow for a relatively uniform set of criteria to be applied to different companies and governments to provide a view of the credit quality of the institution in question. Those simple times are long past gone. For a buyer of securities, they were assurance that someone had given the rated institution a 'once over'. For the least diligent of asset managers, they were an outsourced due diligence process and insurance policy all rolled into one. For the sellers of securities, they facilitated the selling process, applying a 'stamp of approval'. Like it or not, the financial industry has used ratings for several collateral purposes and paid for that process. There’s no wonder that people are shocked and angry. When limited to companies and governments, the rating agencies’ track record didn’t attract attention – with some notable exceptions, ratings had provided a relatively good guide of the credit risk attached to an investment. Even the high profile failures could usually be explained away – as with Enron, or Parmalat, ratings are not designed to detect fraud (though with hindsight, Enron carried a systemic risk with its rating that the market – and the raters – had perhaps underestimated). However, structured finance is more complicated, more susceptible to structural imperfection and easier to manipulate. It is a legitimate way to package and sell risk and its principles are sound, allowing for a 'slicing' of risk to give investment opportunity to people with different risk appetites from the same underlying pool of assets. Accessing a new capital market allows banks to free their balance sheet of assets and provides capital for reinvestment. The structured finance ratings debacle helped to show something that existed all along, but just didn’t show up – rating agencies are susceptible to influence through persuasion, smart marketing – call it what you will. Rating agencies were paid to rate securities. And, in the same way that the investment banks have a standard of care that is difficult to breach to be held 'responsible' for deals that have 'gone wrong', so the rating agencies did not feel that their actions were ones with any inherent flaw.