Thursday, April 29, 2010

Time to rein in the ratings agencies (FT)

Original posted in the FT by John Gapper:

Goldman Sachs executives suffered a marathon grilling in front of the Senate investigations subcommittee on Tuesday. But just as important a hearing of the body – arguably more important – occurred last week.

The organisations on political trial last Friday were the ratings agencies Moody’s and Standard & Poor’s, which played a more central role than any investment bank in the failure of so many investment-grade securities. If all the subprime mortgage securities they rated triple A had not turned to junk, no bail-outs would have been required.

The stories that former Moody’s and S&P employees told at that hearing – of the agencies trying to please investment banks that were paying big fees to get high ratings – cast doubt on a central plank of how the fixed-income markets are supposed to work. Why should investors place faith in these over-rated bond market guardians again?

Ratings agencies have been criticised in past crises – most recently in the aftermath of Enron’s collapse – for lending their approval to dubious bonds and issuers. Their failings in the housing bubble were much greater. Yet, despite shareholder lawsuits against the agencies and some political heat, there is little sign that their quasi-official status – or their business models – will be substantially changed. The financial reform bill that is still blocked on Capitol Hill has placed other priorities, such as derivatives regulation, above them.

That is unfortunate. If the crisis proves anything, it is that the agencies enjoy too much authority among investors and regulators. Any reform that would loosen their grip on bond markets deserves a shot.

This was a triple-A crisis. The banks and insurance companies that came close to failure believed so implicitly in the safety of “super-senior” mortgage debt that they were willing to stuff their balance sheets with it. They would never have taken such a punt on high-yield securities or equity tranches of collateralised debt obligations (CDOs).

In the case of Goldman, it managed to get the Abacus 2007 deal, over which it is accused of securities fraud, rated as investment grade by the agencies. That sufficiently reassured IKB, the German bank with a long position on the deal, and the bond insurer ACA, that they took on the risk that Abacus’s senior tranches would fail – as they did.

The ratings failures went beyond synthetic mortgage CDOs. James Robinson, a non-executive director of the pharmaceuticals company Bristol-Myers Squibb, recounted at the Milken Global Conference in Beverly Hills this week how BMS’s audit committee had questioned its treasury staff about whether they were making any risky investments.

“They said everything was in treasuries and nothing more than 90 days [maturity], triple A. What were they in to the tune of $800m? Auction rate notes, triple-A rated by the agencies,” he said. Mr Robinson said that this cost BMS $600m when the auction rate note market collapsed in February 2008.

It is not only investors and companies that have placed too much reliance on bond ratings. The ratings agencies were first given official status by the Securities and Exchange Commission in 1975 as a means for regulators to assess capital charges for broker-dealers.

Since then, their influence has spread into unexpected quarters. American International Group’s financial products unit, which used its triple-A rating to insure CDOs for banks, offered them a regulatory arbitrage based on ratings. The banks that wrapped senior debt tranches with AIG did not have to set aside so much regulatory capital.

In all kinds of ways, ratings agencies have extended their grip and lulled investors and institutions into a false sense of security. “Throughout the world, the ratings agencies were instrumental in building up a house of cards. They were behind the scenes everywhere you looked,” says James Barth, a senior fellow at the Milken Institute.

What should be done about it? A place to start would be to remove their “regulatory licences” – the status of Nationally Recognised Statistical Rating Organisation – or at least to open the status up more broadly. That might worry regulators who like some official seal of approval, but it would also reduce the halo effect.

Frank Partnoy, a law professor at San Diego University, argues that there is an alternative market mechanism for judging risky investments in credit default swap spreads (which have proved better predictors of forthcoming defaults than ratings). Instead of being told to invest in only triple-A securities, investors could buy bonds with low swap spreads. He also argues in favour of removing the protection that ratings agencies enjoy under US securities law from investor lawsuits relating to securities they rate before they are underwritten. At the moment, they are far more protected than banks or accountants.

Last, politicians and regulators must take a long, hard look at the conflict of interest in agencies being paid by issuers, and so having an incentive to boost ratings. The subcommittee heard stories of analysts being placed under strong pressure to “maintain market share”.

None of these reforms would be easy to implement. Some have been mooted in previous crises without any big changes to the status quo. But this crisis was of a severity beyond others in the past, and triple-A securities were at its heart. It is time to curb the power and influence of the agencies behind them.

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