12/06/2008

Rating The Agencies

The credit rating agencies (CRAs) have attracted a lot of criticism, particularly with regard to mortgage-related structures. The nature of the fall out and the proposed remedies are just one example of a complex chain of events which needs to be put into place before the credit crisis is brought to an end, according to analysis published today by leading investment house, Standard Life Investments.

In the latest edition of Global Insight, its monthly investment view, Standard Life Investments looks at credit rating agencies. Frances Hudson, Global Thematic Strategist, Standard Life Investments, said:

"The turmoil in credit markets has encompassed a large number of sectors, such as investment banks, monoline insurers, and structured investment vehicles. One important part of the system which has attracted much criticism is the credit rating agencies. CRAs have been regularly criticised by commentators following a succession of market crises, for example in Asia, then the TMT bubble, and now structured risk relating to mortgages, particularly in the form of collateralised debt obligations of asset backed securities (CDOs of ABS).

"Hindsight plays an important part. Often in the run up to a crisis, the CRAs have been criticised for being too conservative in their opinions. In this case, the main accusation was that some CRAs had poor methodologies and were slow to react to the fall in value of CDOs stemming from rising levels of defaults on US sub-prime mortgages. Some credit risk has been underpriced, but it is not clear how much of this reflects inappropriate ratings and to what extent other factors play a part, such as the complexity and opacity of many structured products or the lack of risk awareness amongst investors who did not appreciate potential illiquidity. Official reports have indicated how the pursuit by investors of higher returns from ever riskier investments, against a backdrop of low interest rates and easy credit, worked well for a time. When liquidity began to be withdrawn from the system, investors did not immediately recognise the fundamental change that was taking place and its likely consequences.

"Regulators and governments have been quick to blame CRAs for some of the recent market problems, but a close examination of events shows that they have also been culpable to some extent. Indeed, this was admitted by the UK Treasury in its recent report, that there were errors across many parts of government. In addition, though, many investors appear to have misunderstood the true nature of the CRA’s work. ‘Caveat emptor’ is important! As pointed out in the UK Treasury’s recent report on financial stability: ‘it is also essential that investors learn lessons from recent events - in particular to develop a more sophisticated use of ratings’.

"The resolution of the credit crunch is likely to take months, if not years, with financial and reputational damage to many organisations. Other parts of the solution include the relaxation of monetary and fiscal policy while investors need to re-consider the hard wiring of credit ratings into fund mandates which can lead to forced buying or selling. However, regulators will also need to be closely involved in the evolution of many aspects of the financial system, such as overseeing off-balance sheet vehicles, the role of monoline insurers, or in this case the CRAs. Investors must answer a series of questions: Is the business model of the rating agencies inherently flawed? Should CRAs function as quasi regulators? Were they natural scapegoats or a contributory factor? Why did their valuation models not work? Did investors misunderstand ratings and products? What does a rating actually mean? How will methodologies and the rating industry change?

"The rating agencies have shown their ability and willingness to adapt following previous market crises. There is little doubt that, given the opportunity, they will emerge from the credit crunch able to cope with rating structured products for which market value considerations dominate the cash flows from underlying assets. There is also little chance of averting future crises. These will be different in nature and require further changes to rating methodologies and perhaps to the business models of the CRAs, and certainly a further response by the regulatory authorities."