May
30

Who Rates the Ratings Agencies?

By

Published: May 29 2008

It was a debacle. The large ratings agencies – Moody’s, Fitch and Standard & Poor’s – completely misjudged the creditworthiness of subprime mortgages and bonds backed by them. But while there is an urgent need for change, intrusive regulation would utterly fail to prevent similar problems in future, while imposing considerable costs.

Some have gone as far as blaming the subprime mortgage crash on the ratings agencies because, in retrospect, their judgments were wrong. But a lot of other intelligent people were wrong as well. A separate issue is the report by the Financial Times last week that a computer bug resulted in Moody’s awarding incorrect triple A ratings to billions of dollars-worth of one type of complex debt product. That is something that Moody’s must resolve but it is not the primary basis for wider debate about credit ratings.

That debate must rest on what went wrong with the ratings on asset-backed bonds. First, there was fraud in the underlying mortgage applications, so ratings were based on false data. Second, subprime mortgages are a recent innovation, so there were few data on how they perform in a downturn. Third, mortgagors seem to have become more willing to walk away from their homes as prices fall, and ratings agencies did not spot the change.

A fundamental, though intractable, question is whether the inadequacy of the ratings was linked to the conflict of interest faced by all of the ratings agencies. Credit ratings are used by investors but paid for by the issuers of bonds, so the agencies have a financial incentive to keep issuers happy. This conflict could be solved – by, for example, creating an independent body to commission credit ratings using issuers’ money – but that would require the will to push through a fundamental industry upheaval.

Some have proposed straightforward regulation as an alternative – but it would not work. Confronted with byzantine new forms of structured finance and little time to assess them, regulators would either be captured by the agencies, or block all innovation. It would be far better to open up the methodology behind ratings to wider scrutiny, debate and understanding.

That is a change the credit raters must make themselves and it is not the only one. Credit ratings were not just wrong, they were misunderstood, and the agencies’ use of the familiar triple A nomenclature contributed to that. Structured bonds are different to normal corporate bonds both in legal structure and in how they behave. The ratings agencies should adopt new labels to describe them forthwith.

LINK TO ARTICLE HERE:
http://www.ft.com/cms/s/0/972d5cca-2dad-11dd-b92a-000077b07658.html

Categories : Appraisal News

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