The Hindu Business Line : Why weren’t the rating agencies up to grade?

Never before has any single industry come under the scanner in recent times as the ratings industry now with financials institutions falling like nine pins. Investors have always derived comfort from external assurance such as professional audit and credit rating agencies. The recent turn of events in the financial industry have dealt a body blow to the confidence levels. One is certainly intrigued by the fact that all the international rating agencies had assigned AA cred it rating to AIG until May 2008 and suddenly downgraded it just the night before the company was taken over by the federal government under the bailout package. That even the downgrading was to investment grade raises questions over how a company on the verge of significant credit default and bankruptcy could have been accorded that.

Tough questions

Moody’s, Standard & Poor’s and Fitch had assigned AAA and AA ratings to several mortgage securities and other financials without evidently understanding or communicating to the layman the underlying risks involved. An average investor would be the last person to understand the risks in the context of a collateralised loan obligation or commercial-mortgage-backed securities.

In hindsight, it appears that even sophisticated investors took Moody’s and S&P’s assessments at face value. A survey among members of the Association for Financial Professionals a few years ago showed that about 30 per cent of finance managers perceived the credit ratings of their own organisations to be inaccurate; about 40 per cent perceived rating changes to be untimely. The role of credit rating agencies has been under the scanner ever since the sub-prime crisis broke out. The agencies have had to put up a strong defence against accusations that they gave inflated ratings to sub-prime mortgage debt and other discredited bonds in order to attract more Wall Street investment banks that have now failed.

Cartel or flaw?

Going back to the AIG case, one wonders if the rating agencies had factored in the leverage, that is, ratio of borrowings to capital. It was the highest in comparison to its peers at 11 to 1. The entire risk management mechanism of the company was evidently skewed and this, in retrospect, did not catch the eye of the rating agencies.

Moreover, alarmingly, all the agencies have accorded the same rating. This raises questions of whether there operated a cartel or whether the rating mechanism was shallow and fundamentally flawed! Harsh questions, but definitely ones that are crossing the minds of those affected.

“Notching”

The credit default swaps (CDS) — one of the many weapons of mass destruction that caused the current market meltdown — were evidently not put under the scanner by the rating companies. The International Swaps and Derivatives Association estimates that in the US, the CDS market has exploded over the past decade to more than roughly $58 trillion. That is many times the size of the US stock market and far exceeds the $7.1 trillion mortgage market and $4.4 trillion US treasuries market.

One of the allegations that surfaced during the review of the credit rating agencies by the US Securities Exchange Commission was that some of the larger agencies had abused their dominant market position by engaging in aggressive competitive practices. Fitch complained that S&P’s and Moody’s were attempting to squeeze it out of certain structured finance markets by engaging in “notching” — lowering their ratings or refusing to rate securities issued by certain asset pools unless a substantial portion of the assets were also rated by them.

The ghost of Enron

A US government staff report in the context of the Enron collapse had this to say: “In the case of Enron, the credit rating agencies failed to use their legally sanctioned power and access to the public’s benefit, instead displaying lack of due diligence in their coverage and assessment of Enron.

Credit rating agencies did not ask sufficiently probing questions in formulating their ratings, and in many cases merely accepted at face value what they were told by Enron officials. Rating agencies apparently ignored or glossed over warning signs, and despite their mission to make long-term credit assessments, failed to sufficiently consider factors affecting the long-term health of Enron, particularly accounting irregularities and overly complex financing structures.” This clearly shows that nothing has really changed since Enron’s collapse!

One of the major issues we are grappling with is the relatively low level of regulation over the rating industry and process. The rating process has become a virtual financial black-box with little or no clarity on the methodology used. The lack of transparency is something the industry needs to address quickly.

All other independent professional assessment or assurance has clearly laid-out standards, guidelines and reviews. Increased disclosure about rating processes and decision outcomes would also improve their transparency. Again, the ratings have to be simplified to render them understandable to common users; the stringing together of letters with multiple combinations of AAA to CCC with positive and negative signs add to users’ woes.

It is not just a lesson for the credit rating process but for all independent professionals to get back in introspection mode and examine ways in which the investing community’s trust can be regained.

(The author is a practising chartered accountant.)

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