Bridging the Gap between Rating Reliance and Reliability

Despite the implementation of the Credit Rating Agency Reform Act of 2006, five subsequent rulemaking initiatives, and the recent panel discussions among regulators, investors, prominent scholars and representatives of the CRAs shepherded for the U.S. Securities and Exchange Commission (Commission), the investing public still believes there is more to do to restore confidence in the beleaguered US financial regulatory system. Rating performance in the areas of structured credit during the last two years has shaken investor confidence to its core.

On top of that, poor rating performance coupled with rating process weaknesses uncovered by the Commission’s extensive 10-month examination of three major CRAs in July 2008 have raised additional questions of both CRA ratings reliability and the fallibility of the rating process. All of this, in turn, calls into question the appropriateness of using credit ratings as part of the regulatory process. 

It is not unusual, historically, for busts and market failures to increase CRA scrutiny. The major piece of CRA regulation, the Credit Rating Agency Reform Act of 2006, was promulgated in the wake of the Enron debacle and the subsequent Internet /Telecom bust. At the time, investors felt cheated by CRAs because Enron carried an investment grade rating from the major CRAs days before filing for bankruptcy. The current focus on CRAs is likely to produce another quite costly regulatory regime. This is due to two reasons: an unprecedented number of downgrades of structured credit securities, and the perceived CRA failure to foresee the credit crisis. As an internal ratings industry saying goes, you can never spend enough money for due diligence; yet, more regulation doesn’t necessarily ensure greater reliability.

A long history of credit rating 

CRAs have been in the business of assessing the creditworthiness of debt securities for more than a century, long before the Commission was established by the Securities Exchange Act of 1934 to protect interests of investors in the wake of the Great Depression. Since 1900, John Moody & Company has published Moody's Manual of Industrial and Miscellaneous Securities. Standard & Poor's traces its origin to the publication of Henry Varnum Poor's History of Railroads and Canals in the United States in 1860. The other firm that later was merged with the Poor’s, the Standard Statistics Bureau, was formed in 1906 by Luther Lee Blake. In 1941, Poor's Publishing and Standard Statistics merged to form the Standard & Poor's Corporation. Fitch Publishing Company, which later became Fitch Ratings, was founded by John Knowles Fitch in 1913. Located in New York City, the Fitch Publishing Company began as a publisher of financial statistics known to its customers, including the New York Stock Exchange as Fitch Bond Book and the Fitch Stock and Bond Manual.

This long-standing history of the three largest CRAs emphasizes their core strengths in fundamental credit analysis. Corporations, in borrowing money, commit themselves to a certain level of future cash outflow. To meet the commitment, the corporations have an expected, but unfortunately uncertain level of cash inflow, which is to be applied against the obligations.

Fundamental rating analysts are trained to decipher off-balance sheet entities, operating leases, pension obligations and put them back on balance sheets to have a complete picture of a company’s total financial claims. Analysts also consider timing of the debt coming due and treat short-term debt obligations as especially dangerous: if the future of the company gets clouded even for a moment, short-term lenders leave quickly. Rating statistics, which includes rating assignments, upgrades, downgrades, rating withdrawals and defaults, have been accumulated over many decades by the major CRAs and used to gauge rating performance. Rating default and transition statistics have also been used as a model input to back-engineer the credit quality of structured credit securities. 

Accordingly, one of the fundamental assumptions in rating such securities is that the credit performance of structured securities, including securitization and collateralized debt obligations (CDOs), is similar to that of corporate securities. An apparent weakness of such an assumption and subsequent failure of structured credit securities to perform at par with corporates has driven regulators not only to review the entire CRA business, but focus more rigorously on the issues pertinent to the rating of structured securities.

This boils down, in simple English, to the question, “Are all AAA credit ratings the same?” In an attempt to alert investors to important distinctions between corporate and structured securities, CRAs may be required to disclose the models, methodologies and key assumptions on which they base their ratings, as well as to differentiate the ratings of more complex products by adding a specific symbol. 

A question of performance 

The question of a rating performance is the cornerstone of the ongoing debate on how to improve the reliability of credit ratings. The investment public and regulators are both advocating for accurate credit ratings, which they expect to correctly reflect credit risk of a particular issuer or a specific security. It is worth noting that an accurate rating is not necessarily stable. Quite counter intuitively, credit ratings that accurately and timely reflect underlying fundamentals and market sentiments are increasingly unstable. Worsening credit environment and liquidity generally push ratings down while periods of economic expansions and ample liquidity push ratings up. In fact, according to Moody’s statistics of rating upgrades and downgrades, the number of downgrades rises in proportion to upgrades during cyclical downturns and the ratio reverses itself in the periods of an economic boom. 

In addition, the rating transition from an investment grade to a speculative grade usually entails a loss of favorable lending treatments for affected entities such as margin calls on available credit lines and other tougher borrowing covenants. Eventually, the solvency of such a borrower might be questioned. This effect is know as “credit cliff” -- when a potentially accurate, but unstable rating causes chain events leading to the market disruption. The pro-cyclical nature of credit ratings assigned by CRAs has been researched in Howell E. Jackson’s The Role of Credit Rating Agencies in the establishment of Capital Standards for Financial Institutions in a Global economy and in Regulating Financial Services and Markets in the 21st Century by Eilis Ferran and Charles A.E. Goodhart.

While a rating derived from current market observations and trading data may accurately reflect changes in credit quality of the issuer, the rating also has a potentially damaging effect if CRA rating triggers are incorporated into governing documents. The glaring example of such damage is the gigantic chain of credit events stemming from credit deterioration in the relatively contained fringe market of subprime residential mortgage-backed securities. This is precisely the opposite of what is considered one of the major goals of financial market regulation -- to ensure stability and orderly function of the financial markets. If the markets get what they want – that is, timely and accurate CRA ratings -- the flip side is an undesirable reliance on such ratings in a form of rating triggers that threaten the safety and soundness of the financial system. 

One proposal to bridge the gap between reliance and reliability is to establish regulatory control over the integrity of the process, analytical independence and proper management of the conflicts of interests. That is where the CRA regulatory discourse is currently focused, including the recent Commission’s roundtable. The government utility business model for CRA as a way to manage a particular conflict of interest arising from the issuer-fee business model appears very topical, given the current trend towards a heavier government hand in financial market regulation. The government-run CRA model envisions a CRA directed by a government and mainly funded by issuers paying a fee (or a tax) on issuance or outstanding debt. This option is theoretically appealing because the ratings are perceived as a “public good.” 

Ratings v. “opinons”

This option raises serious practical issues with respect to analytical independence. It is not difficult to foresee the government having a natural interest in protecting the “national champions” or companies in which the government has a direct financial interest. Moreover, changing the business model is not going to improve the ability of CRA analysts to anticipate the timing and severity of cyclical economic downturns and account for those changes in the rating assessments. In the current crisis, the independent projections of GDP growth and housing market dynamics made by disinterested economists on staff of government and supra-national organizations turned out just as inaccurate as opinions of analysts employed by the private sector, including CRAs. 

An equally important legal issue to consider is the inconsistent treatment of credit ratings by various market constituents and courts. While investors and regulators treat, or would like to treat, credit ratings as an accurate measure of credit risks, courts define them as “opinions.” Rating agencies themselves consistently define credit ratings as “opinions” of relative creditworthiness. Accordingly, a government-sponsored CRA or a government-funded CRA via a public tax on outstanding debt is likely to perpetuate the existing ambiguity and even encourage investors’ undue reliance on credit ratings assigned by such CRAs due to perceived regulatory approval. 

A credit rating is a snapshot of issuer’s relative credit worthiness, which, as claimed by the CRAs, carries certain predictive qualities. However, the accuracy of such a prediction cannot be guaranteed or otherwise ensured by regulation. Investors should be educated about the limitations of credit ratings methodologies and the cyclical nature of the rating process itself. A review of rating methodologies and assumptions related to the initial rating assignment, credit monitoring criteria, conditions of the rating changes should be a part of such education.

In addition, the burden of dispelling credit rating illiteracy should be placed upon both CRAs and regulators themselves. If a complex adjudication process that results in conveniently short and deceptively simple rating symbols is revealed, investors might then be discouraged from excessive reliance on credit ratings. To limit systemic risk posted by a vicious circle of rating trigger-based lending covenants and margin requirements, banks and other regulated entities should also be discouraged from using CRA ratings in lending documents. Rather, regulated institutions should be required to focus on old-fashioned fundamental credit research, due diligence and knowing their clients. 

It is highly unlikely that CRA rating will be abandoned as some market observers suggest. In fact, quite the opposite view is coming to the forefront of the debate: that during times of instability the need for well-informed opinions only increases. Given the continuing need for these opinions, regulators from around the world are on a long-term mission to come up with a comprehensive set of rules that would govern the process around CRA registration and ongoing oversight of their business activities. This has resulted in CRA regulation that will eventually move away from a reliance on market-based regulation and high-level principles. 

The on-going financial market crisis serves as a strong-enough reason to justify a more pervasive level of CRA regulation, not only in the U.S., but globally. Last month the European Parliament adopted a CRA regulatory framework that includes a mandatory registration for CRAs operating in Member States, compliance with business conduct rules, corporate governance standards and surveillance regime whereby regulators will supervise registered CRAs. The adoption of the regulation will have to be monitored other the next years in order to determine its effectiveness in protecting investors and improving financial market efficiency. Regulators should also be aware of the hazardous side of regulatory licensing of the rating business and take steps to discourage excessive reliance of investors and regulated entities on CRA ratings.

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The views and opinions expressed in this article are those of Ms. Baklanova and are not intended to, and do not represent, the opinions, views or policies of Fitch Ratings or the Fitch Group.

Author bio 

Viktoria Baklanova is senior director at the Fund and Asset Manager Rating Group of Fitch Ratings in New York. Viktoria is responsible for rating money market funds, bond funds, and other public investment vehicles. She is a PhD Candidate, University of Westminster Law School.