Published September 22, 2009

Rating agencies in focus after financial crisis

By VEN SREENIVASAN

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IT has been a year since the infamous collapse of Lehman Brothers.

The episode, which caused panic and signalled a potential meltdown of the global financial system, has been the subject of vigorous debate, with analysts of every persuasion dissecting the cause and effect of the biggest banking crisis since the Great Depression.

Banks - which have been both the cause and victims of the debacle - have become more circumspect in their operations.

Many have tightened their internal controls, including strengthening the 'China' walls separating their basic banking operations from their more risky investment banking activities.

Lawmakers and regulators have, meanwhile, scrambled to craft new oversight rules to prevent the kind of unbridled 'gambling' which brought the global financial system to its knees. And in the spotlight now are rating agencies which played a key role in the near-collapse of the global asset market last year.

The collateralised debt obligations (CDOs) and mortgage-backed securities (MBOs) which imploded in the hands of investors and brought the global financial markets to its knees were all products which carried the stamp of approval from a handful of global rating agencies.

Oligopolistic

The world's leading rating agencies are essentially an oligopolistic group comprising the likes of Moody's, Standard & Poor's and Fitch.

The letter and number ratings (AAA, Aa1, BBB, Caa1, etc) on issuers and products are intended to give investors an impartial insight into the kind of returns they can expect on their investments, and the probability of recouping their capital at maturity. The market relies on the oversight, objectivity and fiduciary responsibility of these rating agencies to publish fair, accurate and uncompromising assessments.

So much so that the ratings on the investment products - bonds, mortgage loans, credit default swaps or other exotic financial products - often influence their pricing and yield.

But the problem with the business of rating is that the rating agencies are paid by the issuers themselves to rate them. This is somewhat akin to a contestant in a beauty pageant paying judges to judge her.

If the bank or corporate does not like the rating, it can take its business elsewhere.

This raises the prospect of 'rating shopping', thus putting pressure on rating agencies to be more liberal than they would otherwise be with their much coveted ratings.

Hence, one US Securities and Exchange Commission proposal up for public comment is whether banks should be required to disclose any shopping that they did among rating companies.

In the case of the CDOs and MBOs, there have been suggestions that many rating analysts may not even have fully understood the product, particularly their complex cash flow structures and the fast-evolving markets for assets which they were based on.

But not wanting to lose business to their competitors, they are suspected of having used the same tried and tested rating models that they had applied to rate corporate bonds to these much more exotic products. Investors, on the other hand, blindly trusted the rating agencies - the same agencies that were paid handsomely by the bank or issuer to come up with the ratings.

It doesn't take a genius to figure out that this was a recipe for disaster. But in the climate of greed and avarice which enveloped financial markets amid skyrocketing asset prices, few had the time or the inclination to take a step back and appraise the scenario.

SEC's move

A year later, banks and bankers continue to be blamed and censured (justifiably, in most cases) for causing the financial crisis.

But there has been very little public discourse on the role of rating agencies, until now.

The SEC has proposed new rules that will improve the quality of ratings among which is a requirement that Wall Street firms get written consent from the rating agencies if they intend to use ratings to sell securities. Such a change would increase liability for the agencies, the SEC said.

The SEC's move to subject rating agencies to closer scrutiny is a step in the right direction.

Rating agencies will continue to provide a very critical role in the financial system as there are currently no viable alternatives. It is appropriate that they now face the same intense calls for scrutiny and accountability that banks and bankers have faced.

In a decade's time, the worst financial crisis in nearly 80 years will be distant memory, and may be nothing more than a great case-study at graduate business schools.

Students will learn about the regulatory failures and the safeguards which were later put in place.

Hopefully, they will also read of changes in the rating process which had unwittingly contributed to the crisis.