The Hindu Business Line : Rating agencies: Fence eating the crop?

Who are the biggest culprits in the US mortgage and financial market crisis? It is a no-brainer: undoubtedly the world’s largest credit rating agencies, Standard & Poor’s and Moody’s.

Their award of prime investment grade to a lot of dubious debt paper is the source of much of today’s problems. So great is their failure that the French Government is threatening to sue them.

Supply chain

The story must start with the supply chain of housing mortgages, which originates from a primary lender (or a broker who earns a handsome commission for his services).

Quality mortgages find a ready market with Fannie Mae and Freddie Mac, the two government-backed entities, which both buy and guarantee such paper.

Other mortgages do not stay in mortgage lenders’ books but are pooled by investment banks and sold to other banks. This is the first level — straightforward securitisation — at which rating agencies come in. Their function is to rate the mortgage loan pool to be securitised.

Enter CDOs — short for collateralised debt obligations — in which already securitised mortgages are pooled to create new securities of different risk classes. It is here that things went awry.

Housing mortgages

Housing mortgages are nothing but retail loans. But rating processes were devised to equate them to ‘AAA’ corporate paper with a better yield, thanks to ingenious minds and raters playing an active role in structuring CDOs such that they could earn investment grade ratings.

This vastly expanded the universe of investors. Institutions barred from investing in sub-prime or unrated paper could now freely buy tranches of CDOs declared ‘AAA’.

Lured by fees

Why did the rating agencies go so far? It was the lure of fees. Rating structured products offered fees which were multiples of those for plain vanilla paper.

It seems to be a case of the fence eating the crop. Rating agencies are supposed to protect investors, who, for lack of or access to information, rely wholly on the rating alphabetical soup for major investment decisions. Ironically, however, they are paid by the issuers of capital. And, as everyone knows, he who pays the piper calls the tune.

Securitisation

Securitisation is still young in India. It is all the more reason for extreme due diligence on the part of raters. There are instances of prime ratings for retail loans which have hardly been seasoned or gone through a complete credit, business and economic cycle.

Bank investors must know that an ‘AAA’ retail asset portfolio is simply not the same thing as equivalent corporate paper and does not justify low yields.

Does the RBI have a role in prescribing a minimum loan history before raters award ratings? Otherwise, it might have to enjoin banks to look into the fine print and mandate norms for rating agencies when they rate retail borrowers.

Exceeding a central bank’s brief? Better that than having to pick up the pieces as the Fed and ECB are now doing.