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Thursday, August 23, 2007

Reforming the role of credit rating agencies

Business Standard has an editorial on rating agencies:

Each crisis leads to incremental improvement of the institutional structure of the global financial system. The “sub-prime crisis” may generate important reforms in the role and functioning of credit rating agencies, which have come under attack for overly generous ratings that misled the market. On the one hand, it is always easy for investors to complain about losing trades. However, genuine mistakes do appear to have been made by credit rating agencies, who under-estimated the correlations between defaults by households, under-estimated the effect of higher interest rates on defaults, and under-estimated the consequences of default upon home prices and thus further defaults.

Such genuine mistakes can be understood when they come from an impartial analyst. But they look particularly shocking in the context of the close nexus implicit in the rating agencies working jointly with financial firms in structuring products, and getting paid handsomely for this work. When the sub-prime market grew from $120 billion in 2001 to $600 billion in 2006, the rating agencies profited handsomely. The behaviour of a paid analyst who is a party to the launch of a product is inherently different from the behaviour of an impartial analyst who is a bystander.

The European Union says it plans to examine the agencies’ roles, and investigate possible conflicts of interest between the agencies and the issuers of mortgage bonds. In Washington, Representative Barney Frank, the chairman of the House financial services committee, is planning hearings in October to examine the same issue.

The first key reform that is now being discussed is to roll back to the pre-1970 situation, when credit rating agencies performed the job of being independent research companies who sold subscription services based on their true merits, and never took payments from the firms that they rated. The second key reform that is being proposed is the removal of credit rating agencies from the regulatory treatment of institutional investors.

The appeal of these proposals is that they would convert credit rating agencies into genuine information and research companies, working at a healthy distance from financial transactions. A rating agency would rate a bond in the hope that investors would like to pay for the subscription service. Institutional investors would judge credit rating agencies alongside other information and research vendors, all of which offer comparable information and research services. In such a world, credit rating agencies would have to pass the market test, instead of being government-supported gatekeepers.

These reforms are particularly pertinent in India, where it is now practically impossible to do a primary issue of a bond without the involvement of a credit rating agency. Fees to credit rating agencies have become akin to a tax. Infosys has zero debt, and its first Rs 1,000 crore bond issue should surely face a good market in a rational world without any credit rating. It is better to trust the processes of the competitive and speculative market, rather than trying to install a set of government-supported profit-making gatekeepers.

Recent Sebi proposals involve mission-creep, from bond issuance to equity issuance. It is proposed that initial public offers (IPOs) should be “graded”. All these criticisms apply equally here. If a credit rating agency (or any research firm) has something useful to say about an upcoming IPO, it should pass the market test of being able to sell a subscription service to investors.

While on this subject, you may like to see this blog entry; We need a better way to judge risk in FT by Charles Calomiris and Joseph Mason; Overrated in portfolio by Jesse Eisinger. Update: The CEO of Standard & Poors resigned, possibly as a consequence of difficulties with ratings of securitisation products. I would always argue that what matters is not individuals but incentives. Witchhunts don't help; our goal should be to reshape the incentives surrounding the bright and well-motivated people who work at credit rating agencies.

Update: Business Standard carries a debate between Susan Thomas and Roopa Kudva on a related theme:

Susan Thomas: Concerns about credit rating agencies (CRAs) have been gathering weight in the world of finance for a while now. Starting from the problems of highly rated companies like Enron which proved to be insolvent, to countries like Argentina, to the more recent problems of the default of sub-prime loans, the reputation of CRAs have been taking a beating over the last two decades. In response, new ways of thinking about credit risk have proliferated. One of the most important alternatives for thinking about the default risk of a corporate bond is the “KMV model” which utilises the stock price to produce continuously updated measurement of the default probability of a firm.

Financial practitioners have already de-emphasised the role of CRAs. In a competitive market, CRAs would have faded away, or reinvented themselves.

The distortion in the role of the CRA comes from the responsibilities vested by the government — when regulators of different financial intermediaries mandated that credit ratings be obtained before these intermediaries could invest in the bonds of firms. This paved the path for firms to pay CRAs to get their bonds rated, in order to get investments from banks or insurance companies. But once the firms started paying for their ratings, the incentive structure for the CRA to do a trustworthy job became bent towards more favourable ratings. This perverse incentive reached a pinnacle with the role of the CRA in helping to structure securitised products such as mortgage loans or sub-prime credit products. Given that there would tend to be a larger fraction of poor credit to good credit in any economy, sub-prime loans was a volumes business that earned the CRAs large profits.

By definition, the sub-prime loans business was also greater risk, which showed up as large losses with the increase in high market volatility of the last six months or so. CRAs are facing the responsibility of what they reaped such rich profits from: as they reaped, so they are sowing. In a competitive market, there would not have been the regulatory mandate the CRAs have benefitted from. In a competitive market, existing CRAs would lose market share to more sophisticated alternatives. India is specially worrisome when it comes to the regulatory responsibility of credit ratings. Listed firms have to mandatorily get credit ratings for bonds; non-government pension funds and gratuity funds can invest only in investment grade bonds with two credit ratings; commercial banks can invest only in rated non-SLR bonds; and the latest peculiarity, a Sebi mandate that IPOs must be “graded”. If these regulatory responsibilities persist in the role of the Indian CRA, then we will indeed have to get serious about “rating the raters”. Instead, if the credit information business can be fundamentally re-engineered so that CRAs pass the market test and compete to obtain subscription revenues from investors, without payments from firms for credit information sent by government agencies, we won’t have to worry about it.

Roopa Kudva: Absolutely yes. And indeed rating agencies are constantly subject to scrutiny, evaluation and questioning by investors, media and regulators. Since ratings are opinions, it is important that markets are convinced about their robustness before acting on them. Rating agencies therefore publish extensive data on rating default and transition statistics, and metrics on predictive capability of ratings vis-à-vis macro-economic and corporate performance. CRISIL regularly holds investor discussion forums where its methodologies and views are hotly debated by about 100 analysts present at each such event.

How should raters be evaluated? Firstly, through a long-term record demonstrating that higher ratings are consistently more stable and have a lower probability of default than lower ones. Adherence to clearly stated and widely disseminated criteria is another parameter. The governance and business practices are critical in evaluating their independence. Some of these include: multi-layer decision-making processes, dedicated criteria and quality assurance teams, prohibition of analysts’ involvement in fee decisions, and analyst compensation not linked to assigned ratings. India’s rating industry scores well on these counts. There is a two-decade history of credible and robust default statistics. Since credibility is its bedrock, the rating industry has proactively and suo motu provided its report card to the market.

The issuer-pays model is much debated, but would investors paying work? When a rating is assigned, the investor is generally not known. Issuers have to commission ratings and provide them to a range of potential investors who then decide whether to invest. And if investors paid, only paying investors would get access to ratings. Markets should not underestimate the huge benefits of the public disclosure of ratings — today all ratings and rating changes are available to the entire market free of charge, as they are widely disseminated.

Rating agencies are the most independent providers of credit opinions compared to other potential opinion providers — borrowers, lenders, investment bankers or brokers. Ratings have a vital role to play in India’s credit markets. The Indian rating agencies proactively alerted the market to the impending risks in the NBFC sector in the 1990s, well before the crisis precipitated. The contingent liabilities of state government guarantees as a risk factor were first highlighted by CRISIL. The potential problem in the collective investment plantation schemes was nipped in the bud by rating agency alerts. The recent actions by CRISIL highlighting the heightened risks associated with leverage in corporate balance sheets to fund their global expansion were keenly appreciated by the market. Not surprisingly, Indian investors’ acceptance of ratings preceded regulatory recognition. Even today, investors demand ratings in areas which go well beyond those where regulations make them mandatory.


  1. “The second key reform that is being proposed is the removal of credit rating agencies from the regulatory treatment of institutional investors”

    This is by far the most important reform needed because ironically the better the credit rating agencies get the more the possibilities that they set is up for some truly catastrophic systemic risk.

    We should never forget that it was the AAA and similar of the credit rating agencies that catapulted some local bad lending policies into a global financial problem, or that those who empowered the credit-rating agencies to have such an influence were the bank regulators.

  2. Talking about the CRA's, just take a look at the current bond yields of the marquee names in Investment banks. Lehman Brothers Holdings bonds yield higher than the sovereign debt of Columbia. Lehman is rated A+ by CRA's yet it is issuing new paper at BBB- rates. Same with Bear Stearns. Today the U.S. market is repricing debt/ credit risk and this has no bearing with the assessmment of CRA's. Here is the Bloomberg link for the article.


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