Risk & Compliance

Restructured Products

A beleaguered credit-rating industry looks to reform itself.
Economist StaffFebruary 8, 2008

Hounding credit-rating agencies has become the bloodsport of choice for moneymen. At a conference this week one speaker announced, to raucous laughter, that he had just received a news flash: “Moody’s has downgraded Fitch, Fitch has cut Moody’s in retaliation, and Standard & Poor’s has put itself on negative watch.”

Politicians and regulators are on the chase, too. Financial regulators, meeting in Amsterdam this week, said they would review a code of conduct for rating agencies, with a view to improving disclosure and clamping down on agencies that give advice on the creation of securities they rate.

The agencies feel that criticism of their role in the crisis was, in part, based on a misunderstanding: their ratings are based on risk of default, not market swings. But, as mortgage delinquencies rise, even they now admit that they were wrong-footed, and that the golden ratings they awarded to many mortgage-linked “structured” products were flimsy, particularly those of collateralized-debt obligations.

In an effort to head off draconian new rules, the agencies have begun to think about changing the way they do business. On February 4th Moody’s said it was considering a new rating system for structured securities, using numbers, not letters, and a suffix that would indicate the expected level of volatility.

Not to be outdone, S&P was due on February 7th to unveil more than two dozen reforms. New committees will oversee governance and modeling and will be reviewed periodically by an outside firm. Information on non-default factors, including liquidity (whatever that is), will be attached to ratings. Like Moody’s, S&P may introduce separate tags for securitized products and will analyz
e the effects of unexpected events. “We need to be clear about what traditional ratings do and don’t do. Increasingly people have inferred more than was intended to be conveyed,” says Deven Sharma, S&P’s president.

Such stabs at self-healing may not placate everyone. Some point to more profound concerns: because ratings are deeply embedded in financial regulation, the agencies have been handed an oligopoly; they suffer a conflict of interest, because they are paid by the issuers of the securities they rate, not by investors; and they are unaccountable because their ratings are deemed mere opinions and thus protected as free speech.

None of these issues is easy to resolve. Switching to an investor-pays system might seem the obvious solution, but it is not clear that enough investors would cough up to make the business viable. Some, perhaps many, would hitch a free ride as ratings leaked.

In any case, agencies can reasonably claim to be tackling their conflicts. Moody’s and S&P have built stronger walls between their analysts and salespeople. Both have vowed to review any rating issued by an employee who leaves to work for a client. “Whoever pays, there will be a conflict,” says Brian Clarkson, president of Moody’s. “The key is to manage it.”

More competition should help, but it might just as easily lead to a race to the bottom, as agencies vie to offer the best terms to issuers. Making agencies legally liable for their opinions, meanwhile, would scare them out of the business.

The most appealing reform, in theory, would be to end the regulatory dependence on ratings and let investors draw their own conclusions from “expert” opinions and market data, as they do with shares. (Even the agencies themselves believe investors should be placing more emphasis on other indicators, such as derivatives prices.) But ratings are so pervasive that it is hard to see this being accomplished without great dislocation.

A more practical approach might be to let the agencies get on with their house-cleaning while introducing a reform borrowed from the accounting industry: a board, made up of industry types, investors and academics, charged with policing the agencies’ analytical techniques and governance. Rating firms have embraced change, but they will need help convincing the world that they mean it.