Reining in the raters

In the economic meltdown, no investor has gone unscathed. Even a giant institution like CalPERS, the US’ biggest pension fund, has been hammered, seeing a preliminary loss in its 2009 fiscal year of 23.4 percent, a drop of $56.2 billion, its worst single-year performance ever.

No one ever accused CalPERS of being timorous. A vocal advocate for corporate governance and investor participation in naming directors, it has always been willing to use the weight of its considerable portfolio to push for what it wants. In July it showed it was willing to use its lawyers as well, filing suit against Standard & Poor’s, Moody’s Investor Ratings and Fitch Ratings.

In 2006 CalPERS invested in three structured investment vehicles (SIVs) – Cheyne Finance, Stanfield Victoria Funding and Sigma Finance – based, in part, on triple-A ratings from the three credit ratings companies. Between 2007 and 2008 the three SIVs defaulted on their payments, and CalPERS claims ‘hundreds of millions of dollars, perhaps more than $1 billion, of investment losses’ resulted.

If it’s been a tough year on the pension fund and other investors, the ratings companies must be finding life excruciating. Investors, regulators, academics and politicians have been unusually united in blaming investment-grade ratings of companies with considerable risk and limited assets for helping to fuel unrealistic expectations in so many investments, particularly a variety of SIVs, which collapsed during the economic pratfall. The smell of new regulation still wafts through the still air on crisp autumn mornings, but there’s a lingering question of whether the proposed regulations – which ultimately, though indirectly, affect corporate bond issuers – will target the right issues and deliver the wanted results.

Missing the point
The inclination toward regulation has been unmistakable. ‘Investors were overly reliant on credit rating agencies, whose procedures proved no match for the complexity of the instruments they were rating,’ Treasury Secretary Timothy Geithner testified in July 2009 before the House Financial Services Committee. ‘In each case, lack of transparency prevented market participants from understanding the full nature of the risks they were taking.’

The Obama administration has already filed its legislative wish list in the Investor Protection Act of 2009, subtitled ‘Improvements to the regulation of credit rating agencies’. There’s a difference between legislation and regulation, however. ‘The Investor Protection Act of 2009 at least has the potential for increasing transparency by requiring ratings agencies to disclose their assumptions, methodologies and procedures,’ says Jeff Gilbert, a securities litigator and partner at Reed Smith. ‘But of critical importance is what regulation the SEC will pass to implement the legislation passed by Congress.’

The parallel with the auditing firms and a push to separate oversight and consulting is clear. ‘The auditors fulfill a very similar role to a ratings agency,’ says Todd Milbourn, professor of finance at the Olin Business School at Washington University in St Louis. ‘We’ve bestowed this market power to mind the gate. When something goes wrong, the raters are the first to be blamed – they are the poster children for all of the calamities of poor risk management practices in the financial market – but I don’t know that they are really any more fallible than anyone else.’

One of the larger concerns of regulation – conflict of interest – is nothing new. In 2002 the SEC held hearings on the topic as a result of SOX. Back then, Moody’s said companies paid anywhere from $1,500 to $1.5 million for an appraisal and bond rating. According to what seems to be the prevalent theory, competition should introduce market forces that will improve the situation. More competition means more pressure on ratings agencies to be accurate, with the reward being attracting more clients and gaining the trust and respect of investors.

But some recent work by Milbourn, in collaboration with Harvard Business School professor Bo Becker, questions whether this conceptual linchpin for ratings agency reform would actually work. Undertaking an econometric analysis of corporate debt instrument ratings over a 10-year period, the pair found that as Fitch entered markets previously dominated by Moody’s and S&P, the rating accuracy of all three got worse.

The result doesn’t surprise Gene Phillips of PF2 Securities Evaluations, a firm started largely by ex-Moody’s employees that offers evaluations of collateralized debt obligations (CDOs). According to Phillips, when it comes to SIVs – his area of expertise – all three of the leading ratings agencies suffer from certain fundamental weaknesses: there is no independent review of their performance; they define the same terms, like the highest grading of AAA, differently, so their ratings cannot be directly compared; and they lack incentive to provide accurate ratings.

That last point might sound curious, but as Phillips explains, no one really wants accurate ratings, at least on the structured side. Issuers want higher ratings because it reduces their cost of debt. Investors not only want a higher rating because it makes it easier to sell an asset, but also – more importantly – because it reduces the amount of capital they need to have on hand.

An incomplete picture
‘The regulators of Basel II told the bank: when you hold assets, we’re going to impute a set amount of capital to all the assets you hold,’ says Edward Grebeck, CEO of Tempus Advisors and a noted critic of ratings agencies. ‘But all AAAs will have the same negligible capital charge. You could buy a AAA tranche of a CDO and pay just a little more than a GE bond for a marginally higher return.’

A top corporate credit risk will have a diversified revenue stream, management that can redirect the business model to meet changing conditions and, in the worst-case scenario, significant assets that could be sold to cover obligations. An SIV, on the other hand, is fixed in structure. Should conditions change for the worse, there is no practical recourse.

Not only do big investors want good ratings at the start, they also do not want ratings to change, lest they find themselves in the double bind of having taken on risk at prices that are now below market while needing to divert capital into covering their positions or to fulfill regulatory requirements. Should the rating drop enough and the investor be an institution required to hold only bonds of a minimum rating level, the investor must dump the paper to other investors who know they are attending a fire sale.

It is certainly difficult to point to any rational arguments as to why ratings in corporate bonds would behave any differently: not only is there no incentive for the firms to provide accurate ratings, but there is also an active disincentive to do so, or at least to be conservative in judgment.

‘Up to within two weeks of when Enron filed for bankruptcy, the agencies had rated it investment-grade,’ says Lynn Turner, senior adviser to LECG and a former chief accountant of the SEC. ‘When Enron was still getting an investment grade but before bankruptcy, those bonds were trading significantly below par. If the agencies had picked up the Wall Street Journal and looked at the bond price, they’d have known the ratings were off.’

The blame game
According to evidence presented by Representative Henry Waxman during hearings held last year by the House Committee on Oversight and Government Reform, it’s likely the ratings agencies themselves realize the accuracy disincentive. Waxman quoted a presentation made by Moody’s CEO Ray McDaniel: ‘The real problem is not that the market… underweights ratings quality but rather that in some sectors, it actually penalizes quality… It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want ratings downgrades; short-sighted bankers labor short-sightedly to game the ratings agencies.’

To put it differently, although the problem with credit ratings sits with the agencies that provide them, sitting at the same blame table are the issuers, investors and bankers who depend on them. Any comfort that the answer to the problem is simply shifting the burden of payment from issuer to investor is thus misplaced.

What will eventually happen is uncertain. The ratings firms are pushing back to keep their processes secret, both to prevent leaks of competitive information and to avoid the ‘pay no attention to the man behind the curtain’ effect. In addition, ratings permeate the entire securities industry and it’s virtually impossible to extricate them. If the unchanged activity of the ratings agencies actually serves the business interests of issuers and investors, it is wise to remember that the total amount donated by the securities and investment sector in the election cycles from 1990 to 2010 has been roughly $656 million, according to OpenSecrets.org. One knowledgeable source who asked to remain anonymous says that ratings agency lobbying diluted a 2006 attempt to place the firms under SEC control so that the regulator could inspect the ratings firms but couldn’t tell them to change their ratings.

And the conditions that favored discussion at least of ratings agency regulation may lose in a meeting with political reality. ‘There aren’t any politicians who are going to get thrown out for ratings agencies issues,’ Turner says. ‘It has to be something that has the attention of the voters, and by the time they go to the polls next November, this won’t be one of those issues.’

But without political pressure, combined with another retreat of economic prospects, chances are that any legislation that might be passed will be watered down, leaving the courts as a potential remedy for those with pockets deep enough to undertake civil action.

Obama administration’s proposed regulation

• Each credit ratings agency would register as a ‘nationally recognized statistical rating organization’.
• Ratings agencies would disclose their methodologies, procedures, assumptions underlying ratings, potential ratings shortcomings, risks excluded from ratings, and conflicts of interest.
• The SEC would have rule-making authority and would annually review each agency for internal controls, due diligence and implementation of methodologies, creating a public report.
• The SEC would establish a ‘system of payment’ to ensure rating accuracy and disclosure of fees charged when issuing a rating.
• Each ratings agency would appoint a compliance officer not otherwise involved in operations or sales who would report directly to the CEO or board of directors.
• Agencies would have to file annual reports and adopt rating symbols differentiating between structured and non-structured investment products.
• Except with case-by-case exemptions, agencies could not provide consulting services to issuers, underwriters or placement agents and then provide a credit rating.