The behaviour of credit rating agencies is back in the spotlight, as Portugal struggles with its large debt burden.
It prompts the question: who rates the rating agencies?
It is fitting that the role and behaviour of such financial “gatekeepers” as Standard and Poor’s, Moody’s and Fitch in 2008’s meltdown is subjected to intense regulatory scrutiny as details of deeply flawed risk calculations, inadequate scrutiny, conflicts of interest - and even racketeering - emerge.
Before the system melted down in 2008, a handful of investment banks and rating agencies were the key players in a largely unregulated global financial behemoth.
By 2008 the finance industry had grown to represent 25% of stock market capitalisation in the United States alone.
This prompted consternation among market observers, including renowned US investor George Soros who expressed concern that the “sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system”.
When the crash hit, one observer noted drily that Wall Street’s investment banks posted losses far exceeding the profits they made in the preceding 25 years.
Rating agencies have played a key role in development of the modern finance industry by rating the ability of companies, such as bond issuers, to make timely repayments of their debt.
But it is worth noting that rating agencies played an equally important role in the finance sector’s near collapse.
Throughout the US housing bubble, rating agencies armed the investment banks with the highest possible ratings for investment products secured by US subprime residential mortgages of dubious credit risk value.
These so-called “Ninja” loans (“no income, no job, no questions asked”) were bundled, repackaged and on-sold by the investment banks to the rest of the world as a premium class of financial investment – thanks to their AAA credit rating.
Following the GFC, regulators in Australia, the US and the European Union have identified a number of structural and operational problems in the rating processes that contributed to the false sense of security afforded by the AAA credit rating.
They discovered that the computer models devised by rating agencies to calculate risks were “essentially flawed”, because they were based on a small pool of data and failed to predict the cyclical downturn in the housing market in the US.
This downturn resulted in a “default contagion”, which ultimately spurred the GFC.
Regulators have since learned that rating agencies routinely accepted the financial data provided by investment banks at face value, without undertaking any proper scrutiny of the underlying assets.
Meanwhile, the sheer volume, complexity and inaccessibility of the financial instruments — some comprising many thousands of pages — made it practically impossible for anyone, including the regulators, to make an informed decision about risks without relying on the rating agencies’ models.
Too close for comfort
Regulators also became concerned about the internal governance arrangements and inherent conflicts of interest involving the rating agencies and investment banks.
In 2008, an examination by the US Securities and Exchange Commission (SEC) uncovered extraordinary procedural irregularities in the way CRAs conducted their businesses.
The SEC found that rating standards had been willingly sacrificed in order to expedite the structured finance transactions. Key participants in the rating process had also been involved in fee discussions and deal structuring with the banks.
There were also well-documented cases where rating agencies downgraded ratings as a means of “racketeering” companies that did not wish to use their services. For their part, the investment banks engaged in “rating shopping” by playing the agencies against one another in order to achieve the highest rating for their products.
Regulators realised that they too had played a key role in creating an oligopolistic and under-regulated industry by encouraging reliance on the ratings in many spheres of public and commercial life.
Australian governments and government-owned corporations in particular have had a long history of reliance on credit ratings. This has been the case not only at the local government level, but also at the level of public fiscal policy and banking standards regulation.
Organisations often face legal and contractual requirements to consider specific investment policy objectives when making investment decisions. These are often expressed with reference to credit ratings.
Critics have pointed out that such practices have given CRAs disproportionate influence in state governments’ public sector processes, because ratings often dictate the way public organisations can raise funds from the financial markets.
It has been estimated that Australian local councils, charities, universities, government corporations and churches invested as much as $4 billion in “junk” bonds during the GFC.
However, in the final analysis it is important to recognise that the rating agencies’ role in the GFC can not be entirely blamed on a lack of adequate internal governance principles, or rules about rating procedures, staff independence or business transparency.
Several years prior to the GFC, the rating agencies voluntarily adopted the International Organisation of Securities Commissions (IOSCO) code of conduct, which sets out in great detail the standards for the rating methodologies, integrity of the rating process, avoidance of conflicts of interest, and risk management.
Rather, the agencies failed to adhere to those standards because there were enormous financial incentives to ignore them, as well as an absence of a robust external supervision regime.
In Australia and overseas, policymakers are now clearly in favour of more prescriptive regulation.
Since last year, rating agencies have been required to hold an Australian Financial Services licence, which is mandatory in the financial services industry and supervised by ASIC.
An AFS licence imposes stringent obligations on licensees to ensure that their services are provided efficiently, fairly and honestly, as well as to have in place adequate risk management systems. Given their chequered history of compliance, agencies are also required to report annually on their compliance with the IOSCO code of conduct.
Unlike the situation in the US, where agencies have often successfully argued that their ratings are merely “journalistic opinions” (and therefore protected by the First Amendment), in Australia they are classed as “financial product advice.”
This means that rating agencies in Australia are liable to investors who can demonstrate that they suffered damage as a result of negligently assigned ratings in appropriate cases.
An important class action is currently being pursued in the Federal Court by local councils in New South Wales who purchased a AAA-rated financial instrument called “Rembrandt,” which, despite the name, quickly lost more than 90% of its value.
While greater regulation of structured finance ratings was inevitable, ASIC will need to balance the perceived benefits of greater regulation in this area against the risk that it may limit the scope of information and quality of services provided by agencies in the general bonds market, which has been functioning reasonably well for many years.
Overly prescriptive regulation tends to distort the informational processes (“asymmetries”) in the market to the point where it may increase the cost of services or reduce competition.
A case in point is the new rule requiring agencies to resolve disputes with retail investors through the financial ombudsman, which has prompted the key agencies to withdraw from the retail market altogether, citing “over-regulation”.
Finding a balanced regulatory framework may be one of the most important challenges for policymakers post-GFC. Only time will tell whether regulators got it right.