“The ratings agency people were all like government employees. Collectively they had more power than anyone in the bond markets, but individually they were nobodies,” wrote financier Michael Lewis in his novel, The Big Short, which lays out the major causes of the nationwide banking emergency that engulfed American – and eventually global – markets between 2008 and 2010.
While this assessment is conveniently oversimplified, it cuts to the core issue inherent in the credit ratings system. Credit rating agencies wield an enormous amount of influence, yet often lack resources, clout and a regulatory framework that would enable them to be more reliable and independent.
To understand the challenges still facing CRAs and the market that relies on their decisions today, it is worth briefly looking back into their role in the 2008 crisis, and how it has evolved in the decade that followed.
From their origination in the early 20th century, ratings services were used to provide independent assessments of bonds and other forms of debt by assigning a grade corresponding to the level of risk that those securities carried. Their role today has changed little, but the structure has become more unified and consolidated, with the ‘Big Three’ – S&P, Moody’s and Fitch – and their global subsidiaries making up 95% of the market since their benchmark status was rubber-stamped into the US financial system through the original 1975 Securities and Exchange Commission (SEC) Act.
Today, these services are relied upon to provide global investors with market insight and informed analysis of the risks associated with most types of debt instruments, including sovereign and corporate bonds, certificates of deposits, collateralized and mortgage-backed securities and innovative types of instruments that often combine features from the above.
Ultimately, their purpose is to independently identify and evaluate the fundamental qualities of a given security and assess the likelihood that an issuer will fail to make timely payments on their liabilities.
The US subprime mortgage crisis, 10 years on, presents an example of a systematic failure of industries and players involved in the market – from the investors that traded the overvalued collateralised debt obligations (CDOs) to banks that structured them, to the agencies that failed to thoroughly analyse and rate them accurately, to the citizens and proprietors who failed to pay their mortgage fees.
Investors were punished by the collapse of the markets, and banks – after being bailed out by the taxpayer – received substantial fines. Meanwhile, CRAs came under scrutiny from the authorities for their failure to accurately assess risks, such as broad declines in house prices and a rise in non-performing loans that followed, or provide a reliable evaluation of the assets to external parties.
The years that followed the credit crisis saw growing pressure mounted on the Big Three – all US based – to reassess their sovereign ratings system. After a series of downgrades of the weaker EU economies, including Greece, Ireland and Portugal, and an across-the-board lowering of ratings in Europe, the EU accused CRAs of unfairly favouring US securities (despite no obvious fundamental or methodological bias).
Many agencies later countered some of these accusations by questioning the stability of the US financial system, with S&P taking the unprecedented step of downgrading the US from its AAA rating in 2011 to AA+, citing concerns over the rising debt ceiling and political deadlock.
In response to the crisis, European and US authorities moved to define, monitor, and regulate the roles of the Big Three more effectively, ensuring that malpractice is held to account. As part of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, the US imposed multibillion dollar fines on a number of agencies. S&P settled for a record US$1.37bn with state and federal prosecutors in 2015, and further agreed to pay US$58mn to the SEC and an additional US$19mn to settle parallel cases by the New York and Massachusetts Attorney General offices. Moody’s also settled a number of cases against it, with some state-level investigations reported to be still ongoing.
The Office of Credit Ratings at the SEC was created in the US, providing the committee with additional oversight authority to scrutinize CRAs on an annual basis, and having power to hand out fines or even revoke licenses if the rules are contravened. The EU set up a similar oversight mechanism, the European Securities and Markets Authority (ESMA), and some European officials have also called for the creation of an independent European rating agency to counter the influence of the Big Three; so far, those efforts have been unsuccessful.
“For the last ten years CRAs have moved a long way. There were mistakes in overinflating ratings of some of the risky assets in the run up to the 2007 crisis, there is no doubt. But we have seen since then more accountability through, on the one hand, a lot more scrutiny from outside regulators, particularly in Europe, and on the other, through more transparent self-regulation,” explained Sonya Dilova, a former Fitch analyst turned emerging market fund manager at BMO Global Asset Management.
“More specific rules were introduced to the rating process, thereby increasing its transparency, namely the disclosing of the daily minutes of the ratings committees. They have been obliged by European regulators to provide the timeline of their scheduled rating meetings for all the sovereigns at the beginning of the year.”
Pay to Play
As these measures were introduced, the fallout from the crisis also pushed authorities and regulators across the world to look for deeper reasons behind CRAs’ failures, and to reform the regulatory landscape to avoid a repeat of the crash. While poor oversight and an abundance of loopholes was largely to blame, many began to point the finger at the conflict of interest inherent in the ‘issuer pays’ structure of the credit ratings market.
Many see this as a deep-rooted problem that is still relevant today, with over 95% of the fee for obtaining credit ratings is currently paid for by the borrowers to the rating agencies.
“I’ve been on both sides of the industry,” Dilova admitted. “The current business model dictates that they are paid by the issuer, but are also obliged by regulations to provide best possible opinion transparently to the investor community.”
Dilova described the example of an issuer coming to market and being rated investment grade, but on a prima vista basis the credit doesn’t necessarily appear to be such. That is because investors don’t necessarily have full visibility on confidential business information that would allow a rating agency to project stronger future performance – which influences an entity’s credit rating.
The reverse situation is also possible. When Bahrain sovereign decided to tap the market with a multi-tranche bond in 2014, it was downgraded one notch by S&P a day after the book was allocated.
Agencies, in their defence, argue that there is no conflict of interest because the rating decisions are made by committees, not individuals, and that employees were not compensated for their decisions. By contrast, they claim, a subscriber-based system, which actually was in place until 1970s, would be prone to even deeper moral hazard in that CRAs could be pressured by investors to upsize the risk estimates in their hunt for higher yields.
“If it is going to be paid by the investor, then there is a bilateral contractual relationship with issuers, so it becomes a grey area of multiple conflicts of interest – whoever pays more,” Dilova agreed. “So perhaps there are some merits to keeping the CRAs relations with the issuer as it is, while they agree to improve their regulatory practices and transparency.”
Another investment manager, who preferred to remain anonymous, conceded that there may be elements of a conflict of interest, but maintained that CRAs navigate around those pitfalls quite successfully – and investors are merely scapegoating them when their strategy fails.
“I think the agencies do a good job and instead I would criticise my investment peers, among whom it is popular to criticise and bash the agencies, often unfairly, but continue to use their information all the time. They use them as a scapegoat in one breath, and as an anchor in the next.”
Some propose a return to the subscriber-pays model that was prevalent before the 70s, but the asset manager is sceptical, claiming that modern investors are not interested in paying for ratings.
“Who pressures them to upgrade ratings anyway? It’s not issuers – it’s the banks. So here’s a solution: all investment bankers who are doing the advisory have to take their fee not upfront, but payable in the bonds themselves. That would level the playing field.”
Other options have been mulled over in recent years. The Reserve Bank of India, for example, has proposed launching an independent fund, from which payments will be made to credit rating agencies out of contributions from the banks and the RBI, according to senior government officials quoted by the Indian Express. The new model will first be implemented for “large borrower” accounts and later expanded to cover other accounts too.
While the proposed plan would only impact a limited number of industries and would not overhaul the existing issuer-pays model, it certainly offers an innovative approach that is bound to catch the eye of regulators around the world.
Short-Sighted Approach?
Another accusation launched at ratings services relates to their methodology, which some studies have shown to be short-sighted in estimating risk for long-tenor debt, and fails to account for some of the long-term local and global trends.
Research conducted by French think-tank 2° Investing Initiative found that equity research analysts and credit rating agencies focus three to five years ahead and tend to overlook risks to the long-term viability of companies, even though the value of institutional investors’ portfolios is mostly based on cash flows beyond five years.
“The financial sector fails to properly assess the impact of the low-carbon energy transition, artificial intelligence and other long-term trends. If assets are not priced accurately investors may suffer unexpected losses and stock market bubbles may form, imposing tremendous costs on society when they burst. Short-term analysis may also miss business opportunities and lead to underinvestment in sectors that can benefit society,” noted Mona Naqvi, Program Manager for the 2° Investing Initiative and co-author of the report, which concluded that a lack of demand from the investment community for long-term research is partly to blame.
At the same time, others have questioned whether the methodologies adopted by agencies focus too heavily on using issuers’ or assets’ recent history as a reflection of future trends. “Credit-rating agencies make the classic mistake of thinking recent financial history is likely to repeat”, Bonnie Baha, portfolio manager at DoubleLine Capital, was quoted as saying in USA Today.
To argue her case, the portfolio manager presented two examples from the subprime-mortgage crisis. The first was the fall of Lehman Brothers bank, which maintained its investment grade rating even after filing for bankruptcy on the presumption that it would be bailed out by the government, like Bear Sterns before it. It wasn’t. Second, the subprime mortgages themselves, which were overrated on the expectation that a 10% decline in the housing market was the worst-case scenario – an estimate that was proven fatally off-target.
Progress has been made since then. The Franken-Wicker Amendment to the Dodd-Frank framework in 2010 created new rules to ensure a review of the methods used to generate ratings. As part of that, a CEO would have to deliver and sign a report attesting to his company’s internal controls every year, while other internal monitoring systems would assess whether conflicts of interest led to rating inflation or otherwise influenced its credit rating.
The SEC added other disclosure mandates, forcing rating agencies to publish their methodologies, credit-rating histories, and additional information for investors. Finally, additional restrictions were put in place to prohibit anyone involved in sales and marketing to play a role in determining a credit rating.:
“The crisis 10 years ago made CRAs become much more stringent and fastidious in the rating process, particularly when dealing with risky assets,” Dilova explained.
CRAs have also changed their approach to investment grade credit, introducing more in-depth analysis that entails discounting some of the data or facts at face-value while also checking and verifying them. That process was originally only applied to the riskiest assets, while developed market assets were assumed to be investment grade by default. These changes in methodology were, among other things, behind the string of sovereign downgrades across Europe.
“If it wasn’t for the crisis, I don’t think this would have happened,” she claimed.
One tricky area for assessing and qualifying risk has been the political and geopolitical circumstances facing issuers. Ironically, CRAs have been accused regularly of both underplaying and overstating such risks, but Jonathan Prin, Managing Director, Head of Research at Greylock capital, thinks that it is the investors, not the analysts, that often jump the gun in such situations.
“I think the ratings agencies are often very proactive in integrating geopolitical events into their ratings. For example, following the attempted coup in Turkey in 2016, ratings agencies very quickly adjusted their ratings to below investment grade.”
Another more recent example, according to Prin, is the Mexican peso and peso-denominated assets, which were swiftly sold-off as the market began pricing in Donald Trump’s victory in US elections.
“And yet there was no change in rating, even though the market effectively downgraded those assets for a brief period,” he pointed out.
Behind the Curve
With many of the above issues becoming hot topics of discussion in the financial and investment community in recent years, it is unsurprising that the rating agencies emerged from the crisis with significant reputational damage. Authors of a recent study titled Does the Market Trust Credit Rating Agencies After the Subprime Crisis? A Comparison Between Major and Minor Agencies suggests the market’s trust in CRAs has taken a significant blow:
“As a consequence of the “certification” role that many regulations recognize to rating agencies, the abnormal return is stronger when the valuation is near to the border between investment and speculative grade. On the contrary, the cumulative abnormal return is significantly lower after the crisis when there is no “regulation-induced” trading.”
Some have gone as far as argue that credit rating agencies have in effect become obsolete, with markets pricing in most decisions well in advance.
“[CRAs] should be seen as but one source of information investors might look to in doing due diligence before buying a financial instrument. And they should be seen as dangerously fallible; their assessments are merely opinions. The credit rating business is a cosy oligopoly; it's dominated by three firms, Moody's, Standard and Poor's and Fitch. Their record is arguably catastrophic,” wrote Sydney Morning Herald’s author Michael Short in 2016.
Still, it is worth turning to another recent study that looked into the conflicts of interest ingrained in CRAs’ business model, which provided an interesting insight, if not necessarily a solution, into the current status quo. The study, conducted by the National Bureau of Economic Research, explored the impact of the issuer-pays model on driving distortions in the rating market.
In a stark conclusion, the researchers surmised that while “there will always be a distortion in this environment that arises from the fact that purchasers of ratings can choose not to reveal them”, the real source of inefficiency was the fact that necessary information was being produced, but was not being utilized by investors.
Furthermore, the additional burden of regulation imposed on CRAs on the back of the credit crisis, combined with continually depressed yields in developed markets, resulted in pressure on these services to provide ever-higher ratings for unprecedented, never-seen-before instruments to satisfy yield-hungry investors.
“The significant problems with credit ratings arose as government regulation became binding on a large investor class and constrained their holdings of risky assets. At the same time the supply of traditional safe assets declined, leading to newly created private sector versions of safe assets and the ratings agencies were called on to rate a richer variety of securities. These privately created assets were both more complex and opaque making them more difficult to rate,” the paper stated.
“Regulatory reliance on ratings and prudential regulation based on risk weighting is a major culprit. Without eliminating that reliance, it will be difficult to overcome the preference of regulated investors to hold assets with upwardly biased ratings,” the authors concluded.
This, then, may be the ultimate take-away of the past ten years, and may help explain the position that CRAs hold in the capital markets. They may get it wrong; they may (at times) even be biased; and there remain conflicts of interest that need to be resolved.
But ultimately, their imperfections are merely a reflection of the faults in credit markets, where investors choose to rely almost exclusively on the expertise of CRA employees at the cost of their own due diligence; traders are eager to get good carry, but are frustrated when those risky assets plummet; and governments set up regulators to empower independent ratings services, only to scold them in the event of a sovereign downgrade.
All of this is to say that, ten years after the credit crisis, perhaps the biggest challenge lies not with the credit rating agencies themselves, but in the market’s expectations and understanding of their purpose.
