The role of the rating agencies in the 2007-2009 credit crisis has gotten more ink than Britney Spears recently. Moreover, the “guilty” verdict on their role is probably the only topic on which all careful financial economists agree. In light of that, what’s in the intermediate future for the rating agencies? On one hand, the former head of corporate ratings for one of the two major agencies expressed concern about the viability of the ratings franchise to me privately as early as 2003. On the other hand, a veteran of one of the agencies who agrees with the “guilty” verdict thinks (with regret) that ratings are so embedded in the psyche of the financial public that it will take 50 years for the franchise to die. In this post, we start with some comments from readers of this blog and add some thoughts of our own:
We start with some thoughts from a sophisticated reader, “DS”:
“In my view, the issues surrounding rating agencies, conflicts of interest, and reliance on ratings are going to be around for a long time to come for various reasons. [These reasons include] the payment of compensation for ratings and the fact that a number of institutions that take on credit risk do not have the infrastructure to perform in depth credit analysis and hence look to outsource this function. I agree that companies should not be placing blind faith on ratings, but some degree of reliance on ratings will remain.
“As regards oversight and regulation, there are some steps that can possibly be taken to significantly reduce the conflict of interest and raise the overall [quality] level of ratings. Some potential possibilities include:
- Capital market issues over a certain size being subject to a “dual rating”. In South Africa, banks above a certain size are subject to dual audit, so why not look at applying the same concept to ratings?
- Auditing of the rating agencies – at present, who audits the ratings performed by the rating agencies? Rating agencies and their work should be subject to audit just like any other company.
- Rating agencies being required to disclose the assumptions that have been used in a rating. This would include assumptions regarding economic growth, forecast default levels, inflation etc. This would place investors in a significantly better position to challenge those assumptions and hence challenge the rating if their views on the assumptions differed.
“Making the rating agencies financially liable for their ratings makes sense in that you would then expect shareholders and management to ensure that the processes that are followed are rigorous and that the companies are not put at long term risk for short term gain. However, I do think that this could open a whole new discussion as to what constitutes a “rating error”. In effect, one would probably have to prove gross negligence, which may be very difficult in addition to which making rating agencies liable for rating errors would probably have the effect of driving up liability insurance costs which would effectively be borne by investors.
“The magnitude of losses that have been experienced over the past 2 years due to “rating errors” significantly dwarf’s the size and financial strength of the rating agencies. So whilst financial claims may effectively wipe out a rating agency, given the magnitude of losses, investors who rely on ratings would be no better off. My view is that in order to attempt to provide investors with a higher degree of protection, not only do rating agencies need to be held accountable, but they need to be subject to audits that are performed by qualified organizations. These audits must include model verification, data quality assurance and process integrity.
We agree with DS that an independent audit of the rating agencies’ performance is essential, as we pointed out in this blog “It’s Time for an Independent Audit of Rating Agency Corporate Bond Rating Performance,” on July 22, 2009:
Recent court rulings have for the first time questioned the rating agencies’ ability to avoid damages for ratings under their traditional defense of “free speech” as Reuters reported on September 3, 2009:
Up until now, however, the only penalty for poor quality ratings (either due to conflict of interest or incompetence) has been the loss of future ratings revenue. As DS correctly points out, a change in the legal protection for the rating agencies dramatically changes the risks from inaccurate ratings, much like this August 29, 2009 story from the Telegraph in the United Kingdom describes for the accounting profession:
I’d like to thank my friend, the eminent Suresh Sankaran, for bringing this article to my attention. As DS rightly points out, the rating agencies’ market capitalization is dwarfed by losses suffered due to their poor performance. In fact, using 230,000 observations of corporate ratings over the period 1995-2004, Kamakura Risk Information Services reports on “implied ratings” that mimic the agencies’ “average” behavior based on company attributes at the time they were rated. For McGraw-Hill, parent of Standard & Poor’s, the implied rating today is BBB+, with a 29.86% probability that the company would not have been rated given its attributes:
For Moody’s, the news is not that good, as they are teetering on the verge of a “junk” implied rating with a KRIS implied rating of BBB-:
The French parent of Fitch, Fimalac SA, is in similar straights with an implied rating of BBB- and a 65% probability of “no rating” given its financial attributes.
How can the U.S. Congress increase the financial pressure on the rating agencies to improve performance during the intermediate period while the current franchise remains? We suggest that there is a precedent that Congress can invoke—the precedence of malpractice insurance in medicine:
- Step one would be the removal by Congress of the “free speech” legal protection for those firms seeking status as Nationally Recognized Statistical Ratings Organizations
- Step two would be a move toward “investor pay” with a legal clause that advises the investor that ratings are “as is” and that the rating agency has no legal liability for errors
- This reduces the probability of lawsuits, but the probability would not be zero, so the rating agencies would make large purchases of insurance against potential “malpractice” lawsuits
- Finally, when ratings quality becomes a concern, this insurance would become prohibitively expensive (just like malpractice insurance for doctors) and the agency would have to make a choice as to whether to continue on a “self insured” basis with the risk of bankruptcy or to give up the NRSRO oligopoly and thereafter offer credit information with the freedom of speech protection.
Note that none of these steps would be necessary if buyers of rated securities made it clear to the underwriters of the issues that ratings are of no incremental value above and beyond the buyers’ own in-house credit analysis, including advice purchased on a “for fee” basis from firms that are not NRSROs. Once that lack of incremental value is understood, no rational issuer would pay for the ratings.
DS, many thanks for your provocative comments. Keep them coming!
Donald R. van Deventer
Honolulu, October 8, 2009