Saturday, August 04, 2007

Sub-prime credit rating agencies

Sean Egan, head of boutique rating agency Egan-Jones and co-founder of some lobbying group designed to get his firm recognized by the SEC as a Nationally Recognized Statistical Rating Organization ("NRSROs" as they are known to their friends) wrote an op-ed in last Thursday's Financial Times (see Sobering lessons of the Bear Stearns losses). Given Egan's previous writings to the SEC and other groups, the FT piece is actually pretty good. Which means, of course, that I doubt he really wrote it. (Must have hired a new PR firm recently.) Egan correctly points out that the Basel II accord has basically made the role of credit rating agencies (CRAs) more important than ever, even as recent structured finance deals and the all-to-predictable sub-prime fiasco call into question whether these CRAs really can be trusted to properly rate the component parts that go into a structured finance deal or a collateralized debt obligation (CDO).

Structured financing and CDOs have become an important part of our economy. In "finance for dummies" terms, these are complex arrangements that let banks or others lend money, and then sell off the IOUs from those debts to other investors. Groups of these IOUs are broken into "tranches" according to the risk that the borrowers will default, and then bits of those tranches are sold off as securities. The idea is that the lender can diffuse its risk among a wide range of investors, each with a different risk preference. You want to invest in rock-solid debt? Then you buy securities from the AAA tranche. You want to take your chances, buy low with a very high chance you'll get nothing, but a chance that you'll make a killing? Then you buy into the "junk" (or sub-prime) tranche. You're an idiot and don't want to get paid back at all? I've got securities in the M.D. Fatwa tranche right here!

In an ideal world, this system is great and, according to some economists, is the reason that the last two recessions in the United States were as painless as they were. (You think they weren't? Then you are a punk and obviously can't remember the early 1980s.)

However, in the latest go around, Egan notes:
Investors in two hedge funds managed by US investment bank Bear Stearns were wiped out in June, which was surprising given that the securities in the funds were rated either AAA - the same level of safety as US Treasury bonds - or one notch lower at AA. Within a couple of months, $1.5bn of capital was lost in only two funds. This development is particularly sobering because, from the obvious indicators, the two funds were insubstantially better financial condition than most banks: they had equitymore than twice that of most banks, at 15 per cent of assets compared with only 6 per cent or 7 per cent for the majority of banks. These funds therefore met and exceeded the requirements of debt-to-equity ratios under Basel II. Additionally, the assets of the funds were rated higher than the typical bank's assets.

This event is a reminder of the weak underpinnings of the mortgage financing market. The problem is a shift in the mortgage business to a situation where all the participants have an incentive to complete the transactions; the mortgage brokers, bankers, investment banks and rating firms are paid if and only if a deal is completed.

This structure is significantly different from the markets of yore, in which a local banker would check borrowers' income and grant a loan only if there was an adequate ability to pay. Even if the banker became too aggressive, there were bank regulators to keep the business on the straight and narrow. One could argue that rating firms today are capable of assessing credit quality and halting the flow of garbage by withholding a rating. Unfortunately, in the ratings field, the tough rater is likely to be the underemployed rater. One of the major rating firms, Moody's, announced last week that it lost market share when it became less liberal than its
Egan's point about Moody's is very good. Moody's recently noted that ever since it toughened up its standards for reviewing commercial mortgage bonds, it has been shut out of 70 percent of this market. (See Moody's Shut Out of Rating Commercial Mortgage Bonds.) Moody's is one of the biggest CRAs and if it is being ratings-shopped, it's not hard to imagine that CRAs may be becoming subject to the same types of pressures that undermined securities analysts a few years ago.

However, as cogent an argument as Egan makes, he actually undermines his point (and his own firm) in his op-ed. In particular, as Egan has consistently noted, the big CRAs are all paid by the issuers they rate. A clear conflict of interest. The big guys argue that if they didn't charge issuers, then no one would pay them since email and fax machines mean that once they issue a rating to even one person, news of that rating travels fast (and the more respected their ratings, the faster the news travels). However, Egan-Jones and other small CRAs are paid by subscribers and investors, and not by the issuers they rate. No conflict of interest, right?

But then Egan writes:
...regulators must pay better attention to incentives. If a rating firm receives 90 per cent of its compensation for ratings from sellers of securities, it is difficult to envision that the interests of investors are paramount. This issue of incentives is all the more pressing given the great difference ratings make to a bank's capitalisation requirements. Under the Basel II accords, $100 of AAA securitised assets requires a bank to hold 56 cents of equity to back up the debt. However, if the bank or fund holds $100 of BBB assets, it has to hold $4.80 of equity - a far more onerous proposition. (Last week Standard & Poor's cut the ratings of several securities from AAA to BBB in one day.) This greater burden of holding lower-rated assets increases pressure on ratings firms, which depend on issuers of debt for business.
Wait a minute. Sure, I get your first point -- if a CRA receives 90% of its revenue from issuers (sellers) of securities, it's hard to see how the CRA will make the interests of the investors (buyers) of these securities paramount. But then you say that, under Basel II, the greater burden investors face in holding lower-rated assets increases pressure of the CRAs to up the ratings. But aren't the banks getting screwed by a lower rating the investors you were just talking about? So who's putting the pressure on the CRAs? Sure, I can see an issuer not wanting a low rating on a debt offering, but once that debt is out there, the pressure will be coming from the banks and investors. And aren't those guys the ones paying your bills, Mr. Egan?

So who's conflicted here?

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