WHO ARE THE smartest operators in global capital markets? Hedge funds? Private equity firms? Investment bankers?
Guess again. There’s only one sector in financial services able to offer a return on equity in excess of 50% while putting zero capital at risk: the rating agency industry. But all is not well in the rating industry: the decline of the US sub-prime sector has thrown into sharp relief the inherent conflict of interest at its heart.
Rating agencies such as Moody’s Investors Service, Standard & Poor’s and Fitch Ratings should be perceived as independent third parties; increasingly they are not. The conflict of interest is obvious: those that they theoretically serve – investors – do not pay directly for the service received. These conflicts of interest cast a shadow over credit ratings, and there are fears that fixed-income capital markets are less efficient because of them. And the problem is only going to get worse: the position of the raters will become even more entrenched as the Basle II regulations come into force.
"The old adage that one cannot serve two masters extends to the financial services industry, including fixed-income ratings," says Sean Egan, CEO of EganJones, one of a small band of independent firms that is paid directly by investors for its research. "It’s extremely difficult to be paid by issuers and at the same time provide timely accurate ratings to investors. We have purposely avoided compensation from issuers; we think that is an inherent conflict of interest." Agencies such as Egan’s often outperform, managing to warn on such big credit blow-ups as Enron, WorldCom, Delphi and New Century ahead of the leading credit rating agencies.
Every few years, investors discover that the rating of a security they are buying is not what they thought it was. But they continue to rely on a system that has failed them before, in large part because of the lack of real competition in the industry.
Concerns are at their most intense in the fast-growing, multi-trillion dollar structured finance sector. It’s a highly profitable area for those involved in structuring and selling deals. It is also the area in which the relationship between investment banks and rating agencies is closest. And that relationship is about to come under greater scrutiny, as investors threaten legal action to recover losses on their sub-prime investments.
Concern arises over the interaction between agencies and financiers in this field because of the complexity of the structures involved. The ratings that structured securities receive are the product of many factors, which can appear subjective.
Sometimes the agencies take substantially different viewpoints on a sector or an individual credit. When constant proportion debt obligations first emerged in 2006, there was a lot of confusion at investment banks over these deals. The idea of a security rated triple-A that offered a spread of 200 basis points over mid-swaps was difficult, if not impossible, to fathom. ABN Amro went to the rating agencies with the idea for CPDOs, then followed up with months of work to get the transaction off the ground. With any new product such as this, the agencies are closely involved in the design – without their stamp of approval, many investors would not be able to buy it.
Flipped dynamics
CPDOs were created because ABN Amro wanted to give investors that liked credit constant proportion portfolio insurance (CPPI) products a rated and defined coupon, rather than the principal protection associated with CPPI. ABN cleverly flipped the dynamics of CPPI using the credit indices as the underlying asset.
However, Moody’s and S&P have since come under direct fire from competitors such as Fitch for giving triple-A ratings to the first wave of these structures. Last autumn – shortly after the launch of the first deal – there was much talk about Moody’s and S&P becoming alarmed at an extensive and sudden tightening in the underlying credit indices, which was largely linked to market participants ramping up CPDOs.
Ultimately the debate over these securities centres on methodologies. Fitch argued that the key performance parameter (the liquidity of the iTraxx and CDX) is only available for four years, while CPDOs have a maturity of 10 years. And the rating is not so much about default risk – the traditional domain of the agencies – as about spread risk, the roll-down of the index and bid/offer levels.
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Volatility in Sub-prime foreclosures |
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Rate of foreclosures as a percentage of loans, 1998–2007 |
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Source: DB Global Markets Research |
It’s a sign of how low the rating agencies’ reputation has fallen that some market participants have speculated, unfairly, that the real reason these deals got their triple-A ratings was because the agencies knew that it could open a lucrative new business line. The structured finance industry was certainly at first surprised that this product got off the ground.
But banks quickly set about copying the idea and making their own deals – the compensation structure at banks offers little incentive for sitting on the sidelines. The same goes for the ratings agencies. They are profit-maximizing businesses. But they must balance the revenue imperative against the long-term threat to their reputation from getting analyses wrong.
"Our methodology for rating CPDOs is rigorous, we stress-test a very wide range of credit and market risk scenarios, and we are comfortable that our rating opinions are appropriate for existing CPDO structures," says Martin Winn, a spokesman for S&P in Europe.
Winn acknowledges that the rating of CPDOs involves far more than just default risk. But this is not a new trend. "We have been successfully evaluating market risks on the asset side of structured finance transactions for over 15 years, as part of our wider coverage of structured products such as structured investment vehicles, market value CDOs and more recently, leveraged super-senior CDOs," Winn says.
Speak to almost any market participant, even those with an axe to grind, and they will readily admit that the rating agencies play a key role in facilitating easy access to the capital markets for issuers.