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Rating Credit Responsibly

By Anthony Hilton, financial editor, London Evening Standard

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The answer to successfully regulating the ratings agencies is surely to reduce their role and open up the market.

The head of one of the big investment banks once explained the economics of derivatives based on subprime debt in the following terms. “We buy a package of debt for 90 cents. We spend two cents having it rated and three cents having it insured and we can then sell it for 100. Why wouldn’t we do it?”

Now that the world has been brought to its knees by the implosion of the derivatives based on sub-prime debt, that banker has an answer as to why it was not such a good idea. But his analysis remains useful because it shows how central to the whole process the role of the rating agencies was. It was their willingness to express an opinion on the investment quality of those derivative securities that allowed them to be sold. Investors around the world did not really understand what was inside these complex products and therefore did not understand the risks. But they took the view that if the rating agencies said these financial products were safe, then that was good enough for them.

However, when some months later the losses on these products began to mount, these same investors naturally felt betrayed. The rating agencies that for a generation had been among the humdrum, little-noticed, back-office artisans of the financial world now found themselves in an uncomfortable spotlight. They were blamed for giving their seal of approval to products they did not fully understand. They were accused of conflicts of interest. There were widespread demands that new rules should be brought into being to prevent such mistakes in the future.

In truth it was as much the investors’ fault as that of the rating agencies, insofar as the latter never gave a view on the marketability or liquidity of securities or the distortions in price that follow if liquidity dries up. Much of the plunge in prices was caused by a loss of liquidity, not default. For this the rating agencies should not really be blamed.

Thus it is that the humble rating agencies come to be on the agenda for the Pittsburgh G20 Summit – a public profile that would have been inconceivable for them even a few months ago.

This does, however, reflect the complexity of what they do, the limited understanding even now of their role within the system, and the fact that no two agencies are alike in their processes and objectives and that no one feels the proposals outlined so far have cracked the problem.

The first, most obvious difficulty is conflict of interest. The rating agencies are paid not by the investor or the government but by the company issuing the debt or the investment bank packaging the derivative. This does not mean that rating agencies simply do what their paymasters tell them – they would lose all credibility if they did. But it does mean that the links between the two are unhealthily close in that the rating agencies were willing to advise the banks on how the products could be structured to get the best possible rating.

Clearly this form of payment is unsatisfactory. The problem is what to put in its place, as investors are not willing to pay the rating agencies directly. One answer the G20 could consider would be to insert an intermediary into the process so that the issuer pays the intermediary and the intermediary then pays the rating agency.

This halfway house would seem to be preferable to alternative proposals that suggest, in effect, that rating agencies be nationalised and the rating of debt becomes a public service. This would probably work in the short term, but problems would emerge quite quickly. One is that debt is an international market, and inevitably the credibility of one government’s rating apparatus would be less robust than that of another. It would follow that the AA rating issued by one country might be less stringent than the AA rating issued by another. This would damage the credibility of the process and lead to rating arbitrage – where issuers shop around for the softest jurisdiction – for the simple reason that the higher the rating the more cheaply they can issue the debt.

Another problem that the G20 could address is that of monopoly. There are currently only a handful of agencies, all of which were originally authorised by the United States Securities and Exchange Commission (SEC). Although the agencies compete with each other, there is no competition in the accepted sense. Rather, there is what is often called ‘group think’ – the agencies all approach the task in similar ways. This delivers some interesting effects. A Standard and Poor’s rating claims just to address the possibility of default while a Moody’s rating assesses default and the amount of loss that will result from that default. Yet while they measure two different things, the two firms almost always give equal ranking to the same debt instrument. This suggests that, rather than being objective and competitive, they keep an unhealthy eye on what the other is doing, on the basis that if one appeared much tougher than the other it might lose all its business.

The answer surely is to open the market to many more firms, and to take the responsibility for their authorisation away from the SEC and give it perhaps to an international agency. But it is an open question whether the Americans would ever agree to this. The American financial markets remain the most powerful in the world and the Americans typically refuse to recognise any regulatory authority other than their own. However, these are international markets and they need an international agency.

Another issue the G20 could address is what it is seeking to regulate. Is it concerned with the right of the agency to exist, an insistence that its people are properly qualified and that it manages properly the conflicts of interest outlined above? Or is it concerned purely with the method of regulation – the process involved and what the rating actually means?

If it is the latter, might the G20 have a role in mapping out an objective and common standard to measure credit risk and let the agencies map their ratings on this scale? While it is at it, the G20 might also address the philosophical question of whether it is wise to have ratings play such a central part in the regulatory system and in particular as the determining factor in the calculation of bank capital. This gives ratings an importance in the system that is far beyond the original intentions of those who designed it. It is inevitable that when something is stretched to such an extent, it becomes distorted. The long-term answer surely is to reduce their role and restore them to their original purpose as a guideline to quality, not a guarantee.

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