As a consequence of the sub-prime crisis, one key component of the value chain is under scrutiny. Lynn Strongin Dodds reports
While central banks, investment banks and regulators have come under fire for their mishandling of the credit crunch, the ratings agencies have been chastised the most. The hand-wringing has now begun in earnest and 2008 is likely to see a reform in risk analysis techniques.
The main question being asked is why the rating agencies failed to flag the dangers associated with mortgage-backed securities (MBS). Despite the widespread awareness of the problems in the su-prime sector in the first half of 2007, the big three - Standard & Poor's, Moody's and Fitch Investors Service - did not downgrade mortgage bonds and related structured debt products until mid-July.
Since the summer, there has been a deluge of negative assessments. Recent research conducted by Deutsche Bank reveals that the three main agencies have overall downgraded almost 20,000 individual asset-backed securities due to sub-prime woes in the US. By contrast, there were just 2,539 downgrades in 2006. The research notes that investors have not only been shocked by the level of downgrades but also by the degree to which the downgrades are affecting the highest-rated universe of securities. Before 1999, no AAA structured finance transaction had ever been downgraded because of the performance of a pool of securities.
The main bones of contention are the lack of robustness in the rating agencies' due diligence process, as well as the shortcomings in their basic mortgage models in analysing the sub-prime loans. Problems were exacerbated because many of these loans were packaged into residential mortgage-backed securities (RMBS), which in turn were parcelled into collaterised debt obligations (CDOs). CDOs are typically layered with different tranches that are based on the returns they offer and their perceived ability to absorb losses in the event of a default.
Critics believe that the rating agencies were too reliant on performance data for the more traditional mortgages - such as those issued by the government-guaranteed mortgage agencies Fannie Mae and Freddie Mac. These bore little resemblance to the new wave of sub-prime home products such as the so-called ‘low and no document' loans which enabled people with little or no credit history to enter the housing market for the first time.
Moreover, the rating agencies have been slated for seemingly relying on the underwriters to conduct the necessary due diligence on risky mortgages and the borrowers supporting them. In their defence, US securities regulation only requires firms to assign ratings based on the information provided by the underwriters, and they are not obliged to ask for further data. Looking back, that proved to be a mistake and market participants now believe that rating agencies should have been more rigorous in their analysis.
The main bet at the time, though, was that house prices were going to continue to escalate, enabling borrowers to pay off their debt. Few if any industry pundits predicted that the Federal Reserve would regularly crank interest rates higher over a two-year period, causing house prices to slide and delinquencies to rise.
According to Simon Martin, managing director and head of research and strategy at Curzon Global Partners, an affiliate of AEW Europe, a London-based investment management company: "When the agencies rated conduits that held pools of sub-prime or near sub-prime residential mortgages, they did so without much historical default or recovery rate data but on models. In essence, these ratings often made what was not good credit feel like very near prime credit. It would not have been uncommon to see near-junk-rated sub-prime paper packaged into a CDO which would have had large tranches of high investment grade rating. This ‘credit enhancement' meant that the paper became worth more, delivering a healthy profit to the bank that conducted the securitisation."
All agree that more emphasis should have been placed on the dynamics of the economy and the impact different scenarios could have had on the riskier end of the loan spectrum. Jamie Lyon, director of finance and operations Europe, LaSalle Investment Management, notes: "Until the sub-prime crisis hit, the recent years' market conditions had been described as a ‘perfect storm'. The economy was stable, volatility was low and debt was cheap."
However, the buoyant property markets attracted less-sophisticated investors while, at the same time, increasingly complex financially engineered products were introduced, packaged and sold at very tight pricing. Many did not fully understand the risk inherent in these deals and were swept away by the exuberance of both the rating agencies and to a certain extent the investment banks, where perhaps underwriting standards and models were less stringent in such a market of ‘perfect storm' conditions.
"Now there has been a sharp intake of breath, a recorrection and, although underlying property fundamentals remain strong, there will be much more emphasis on economic fundamentals. Will the commercial and residential asset-backed securities market come back? Probably, but maybe not in the coming year and it will look different from what we have enjoyed in the past."
Mayiz Habbal, managing director of the securities and investments group at global consultancy Celent, adds: "One of the main problems was the rating agencies relied on quantitative models and there was no fundamental evaluation of the real estate market itself. They did not correctly factor in the growth limitations of the market and like the internet bubble when market saturation was reached, the rise in prices ended and the growth cycle broke down."
The analytical acumen of rating agencies, however, is not the only issue that has come under the spotlight. Their basic operating model is also being examined. As Adam Sussman, senior analyst at US based consultancy Tabb Group, notes: "There have been long-standing concerns over the rating agencies' business model. From an outsider's point of view, there is a conflict of interest because these firms are supposed to issue the rating on behalf of the investors but it is the companies that are paying the bills."
So far, the regulatory screws have not been tightened but there is no doubt that the major rating contenders are in the hot seat. The main areas to be reviewed include reducing conflicts of interest and tightening professionalism and consistency. In addition, they will be looking at whether the firms should implement a regular review of debt issuance in order to provide more timely and accurate information to the market, as well as lessening the potential influence an issuer could wield.
In Europe, the EU market watchdogs intend to meet with the rating groups to discuss their part in the sub-prime mortgage crisis. Moreover, the International Organisation of Securities Commissions (IOSCO), representing more than 100 securities regulators, including the UK's Financial Services Authority, will set up a taskforce to assess the role of the agencies, which could possibly lead to greater regulation.
In the US, the Securities and Exchange Commission (SEC) is conducting its own probe as to whether rating companies were improperly swayed by issuers and underwriters of MBS to publish high ratings. The SEC will also be looking into whether the agencies followed their stated procedures for managing conflicts of interest.
This is not the first time that rating agencies have come under scrutiny. They were heavily criticised for not spotting the accounting errors in the corporate accounting scandals at Enron and WorldCom in 2002. This also produced a raft of proposals. In 2003, for example, IOSCO drew up a code of conduct for rating agencies, which touched on many of the issues that are being investigated today.
While the organisation does not believe the code was ineffective, it notes there is still room for improvement, and it will focus on the development of the structured finance market in its latest review.
The corporate fallout also led to the passage of the Credit Rating Agency Reform Act of 2006 which aimed to loosen the grip of Moody's and S&P, who together account for a hefty 80% chunk of the ratings market. Fitch is the next largest agency, with a 15% share.
Other nationally recognised organisations, such as AM Best, have a fraction of the market, although the regulators were encouraged to see the arrival of two new firms in June - Japan Credit Rating Agency, and Rating and Investment Information.
The Reform Act also enabled the SEC to inspect the books and policies governing ratings firms, but the law prohibited the regulator from second-guessing rating decisions. It stated that the agency cannot substitute its judgment for that of the rating firms. However, now some market participants and policymakers are calling for more sweeping reform.
Although it is too early to predict the outcome of these investigations, Martin says: "The question for me is not whether the agencies can develop a better way of modelling or rating these loans. It is more fundamental than that. It is whether the rating agencies can be trusted to do the job without some sweeping changes to the regulatory regime that they operate within. Some in the industry say that this is the technology crisis all over again and that Sarbanes-Oxley was the price that the banks had to pay. I very much doubt that the agencies will escape this credit cycle without some form of increased scrutiny."
Not surprisingly, the rating agencies are fighting back and undertaking their own internal review. Gareth Levington, team managing director, structured finance, Europe at Moody's, notes: "We are doing our own soul searching. We made assumptions based on available information at the time but it did not play out as expected. Everyone agrees that we need to revisit those assumptions and we are now internally looking at ways in which we can improve our service."
For example, Moody's is looking at overhauling the way it rates complex financial instruments to analyse for the first time how these products might behave in a liquidity crisis. Such measures of so-called ‘liquidity' and ‘market value' risk could be issued alongside the traditional ratings, which currently just indicate the risk that an instrument will default. Recently, in Europe, the firm launched its performance data service, which aims at providing greater transparency on the performance of structured credit products. Investors will receive an ‘early warning system' that will enable them to detect risks and track the performance trends of bonds backed by residential mortgages.
S&P is also making changes. A spokesperson for S&P adds: "It is now clear that some of the assumptions we made with respect to rating US RMBS backed by recent sub-prime mortgages were insufficient to stand up to what actually happened. We are responding by looking for further ways to enhance our processes and analytics.
"Recent steps we have taken in relation to US mortgage-backed securities include increasing the frequency of our reviews, modifying our analytical models and improving the quantity and quality of data available to us. We are also working closely with the market and regulators to improve understanding of what our ratings mean, how we arrive at them and how they perform."
The spokesperson for S&P also defended its performance, saying: "Our role is to provide independent, impartial credit rating opinions on the basis of the information available to us. Our track record of rating structured securities, including mortgage-backed securities, over the last 30 years suggests we have been doing this pretty successfully."
Since 1978, the average five-year default rate for investment-grade structured securities is less than 1%; for speculative-grade securities it is just over 15%. The equivalent default rates for corporate ratings are just over 1% and around 20%.
Equally, it is important to put the rating actions into perspective. According to the spokesperson: "Our downgrades of US RMBS securities (comprising sub-prime and prime) have impacted less than 3% of all rated RMBS securities on a dollar volume basis for the period from Q1 2005-Q3 2007. Only around 1% of our AAA-rated RMBS bonds have been impacted. It is also worth remembering that an S&P rating is an opinion about the probability of a security defaulting, not about its market performance.
While the current liquidity crunch is very real, we have not witnessed widespread defaults of securities, which are what our ratings specifically address."
Last but not least, Fitch Ratings is also making amends. Starting in January 2008, the firm will strengthen its analysis of the origins of the mortgages backing the deals it rates. Its reviews will include the originators' due-diligence reports and portfolio statistics, as well as on-site interviews with senior management. A company statement said that "in order to detect and prevent poor underwriting and fraud, a combination of technology and basic risk management is needed not only before, but also during and after the origination of a loan".