Credit Rating Agencies Again Playing a Vital Role in the Marketplace?
In an op-ed about high-frequency trading in Monday’s Wall Street Journal, former hedge-fund manager Andy Kessler suggests that poor pricing of collateralized debt obligations between 2006 and mid-2008 were a significant reason for the crisis that arose just two years later. On the basis of that bad information, he contends, the market continued to buy these toxic instruments until better models appeared two years later. He concludes that the “financial crisis was mainly driven by the drop in value of mortgages from these last two years.”
Some, like the Financial Crisis Inquiry Commission, may quibble with Kessler’s assessment on the importance of this aspect of the failure, but it’s hard to argue with him about the failure of the market to price such instruments in the heady days of 2006 and 2007. And few entities were more responsible for the mis-pricing of collateralized loan obligations, not to mention mortgage-backed securities and other structured instruments popular at the time, than credit rating agencies. The failure of the Big Three — Moody’s Investors Service, Standard & Poor’s Corp., and Fitch Ratings Inc. — to assess the credit quality of the underlying assets, to gauge the magnitude of potential decline in US real estate values, and to evaluate the manner in which these instruments would perform in such an environment helped delude investors into a false sense of security. Hence the over-pricing of the junk traunch of a portfolio of junk traunches of subprime mortgage pools.
Now, nearly seven years after the first quakes in the structured market, the question on the mind of some policy makers in the United States, Europe, and the International Organization of Securities Commissions is whether the CRAs are sufficiently reformed and sufficiently respected to resume a vital role in the marketplace. The answer is maybe.
To assess investors’ perspectives on the CRAs’ atonement for their failures, CFA Institute recently surveyed global members who invest in the fixed-income sector. This was the first CFA Institute survey on this issue in five years, when 60% of members globally questioned the validity of credit ratings. That survey also produced the interesting and newsworthy highlight that 11% of respondents said they’d seen a CRA change its rating due to pressure from an issuer.
This time, the assessment is nowhere near as raw as it was in 2009, but investors still don’t fully trust the rating agencies. For example, 82% of respondents said they still believe rating agencies are under pressure from issuers to give them higher-than-deserved ratings, largely because the issuers are paying the CRAs. As a consequence, 84% of respondents said they are more cautious today about credit ratings than they were seven years ago. Indeed, while most large investors say they once again give credence to the ratings of the CRAs, they now use those ratings as one of a number of inputs into the investment decision-making process. See Gretchen Morgenson’s recent article in the New York Times for an example of how large pension funds still reference ratings in their very voluntary investment policy statements.
That said, investors have recognized an improvement in the processes and quality of ratings since 2009. In the 2014 survey, 68% said they believe the validity of the ratings has improved, and 62% said they believe the rating agencies have adjusted their procedures on conflicts of interest as a consequence of the turmoil of the last decade. Just 51% believe the improvements are the consequence of regulators’ actions on this front.
The business models of CRAs remain a sticking point, however. On the one hand, 52% of respondents said that regulators need to take steps to eliminate the issuer-pays business model to reduce the conflicts of interest they create. In response to a separate question, however, 60% said they believe all CRA business models — including investor pays and assigned ratings (wherein the regulator randomly chooses which CRA will rate an offering; just 13% supported this idea) — have conflicts of interest. And the best way to deal with these conflicts is to increase transparency about agencies’ rating methodologies and performance. From there, it should be up to investors to decide how to use the ratings.
While large investment firms are able to deal with the new arms-length approach to rating agencies, it is a different matter for small funds and firms. These typically lack the in-house resources to do their own analyses. Consequently, they are potentially as wedded to the CRAs’ opinions as ever, and certainly to a larger degree than larger competitors. It is for this reason that the agencies must improve the overall quality of their work.
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