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July 22, 2010

Raising the Standard

By Spear's

Standard & Poor’s Tony Angel acknowledges the recent failure of his own and other rating agencies, but sticks up for their inherent usefulness

Standard & Poor’s Tony Angel acknowledges the recent failure of his own and other rating agencies, but sticks up for their inherent usefulness
IS THE MODEL under which the major credit-rating agencies operate still viable? It’s a fair question, given the market turmoil we have experienced, and many market participants — investors, bond issuers and regulators — have asked it. Given the disappointing performance of the ratings of some mortgage securities in recent years, it is natural for people to wonder what can be done to improve ratings, and even to ask if there might be a better compensation model than one in which issuers pay rating agencies.

I should start by noting that we were quick to acknowledge that our ratings of US residential mortgage securities, particularly those issued between 2005 and 2007, did not perform well, and we profoundly regret that. Although we stress-tested these ratings to withstand as much as a 20 per cent decline in housing prices, we did not anticipate the speed and severity of the downturn, which in some parts of the US led to housing-price declines of as much as 60 per cent. We were not alone in estimating a less severe decline. Indeed, few in the marketplace were far-sighted enough to foresee just how far housing prices would fall.

But it is also important to remember that during this same period, our ratings of corporate and sovereign debt, securities backed by credit cards, auto loans and equipment leases, and even mortgage-backed securities issued in Europe, have all performed as we expected, despite using the same analytical approach as US mortgage securities and, of course, within the same business model.

Nevertheless, we recognise that confidence in ratings has been shaken and must be restored if the credit markets are to function efficiently. Over the past few years, we have taken a hard look at our ratings, and we have worked closely with market participants to understand their concerns and answer their questions.

One common question is whether conflicts would be eliminated if investors paid for credit ratings. This assumes that subscriber-paid compensation is free from conflicts of interest, and this is just not true. While an issuer of debt prefers to receive the highest possible rating for his bond, an investor would rather have a lower rating because it decreases the price and offers the possibility of arbitrage should the rating be upgraded in the future.

It is sometimes argued that if investors benefit the most from ratings, they should pay for them, but most investors are not in a position to pay subscriber fees to a rating firm. The issuer-pays model allows us to publish our ratings free of charge on our website, whereas the subscriber-based model creates information ‘haves’ and ‘have-nots’. Market coverage is also a significant factor. A subscriber-based firm has no incentive to develop ratings that investors have not agreed to pay for, making it potentially difficult for new issuers to get ratings and for investors to learn about new opportunities.
A THIRD-PARTY BOARD that would separate rating agencies from issuers has been suggested, too. Policymakers are striving to reduce reliance on ratings by eliminating references to ratings in banking and securities rules. S&P emphatically supports that policy. Creating a state-sponsored or state-run third-party board to mandate ratings firms would run counter to that policy.

Moreover, if rating engagements were assigned by a random or a ‘next-in-line’ basis, credit rating firms would have less incentive to compete with one another and pursue innovation. Then what can be done to improve ratings quality and manage conflicts? Our approach has been to take a top-to-bottom look at our ratings and implement changes in our policies, procedures and criteria.

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For instance, we have made changes to our criteria for rating mortgage securities so that it will be much more difficult for such a security to receive a ‘AAA’ rating. We have greatly enhanced our already robust system of checks and balances to maintain analytical independence.

In addition, our credit analysts must pass a rigorous certification programme designed by New York University’s Stern School of Business. We have further strengthened our firewalls that separate analysts from commercial activities. And we have embraced new levels of transparency that allow investors to see how we arrive at our ratings and to agree or disagree with our opinions and act accordingly.

We believe that issuers and investors should have a choice of firms using different compensation models, so long as potential conflicts of interest are disclosed along with the steps firms have taken to mitigate them. We also believe that investors will always need independent assessments of credit risk as part of a complete examination of investment suitability.

Even during traumatic dislocations in the global economy, we have seen a positive development: investors better understand the need to analyse all facets of risk — not just creditworthiness — in making decisions. This should help bring greater stability and fewer shocks to the system. 

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