AAA and AA insignia allayed the reservations of market participants, who relied on them to throw caution to the winds. The coveted AAA grade created a false sense of security--conveying that an instrument was at least as safe as a typical investment-grade corporate bond and highly unlikely to default. As long as rising property prices and declining interest rates held the house of cards together, issuers skirted losses and criticism. When the cards collapsed, the models for assessing mortgage pools and structuring the securitized deals finally came under scrutiny.
A Privileged Oligopoly
The predecessors to today's rating agencies began over a century ago, offering research on the risks of railroads and other bonds, explains Richard Herring, Jacob Safra Professor of International Banking at the Wharton School of the University of Pennsylvania. That earlier system was less subject to conflicts of interest, since rating companies made money by selling their manuals to investors, who would buy more manuals if the credit assessments turned out to be accurate. However, the advent of the Xerox machine enabled other users to photocopy the manuals, compelling the rating firms to turn to issuers for compensation.
By the 1970's, issuers, rather than investors, were funding the model. The three primary rating agencies--Standard & Poor's, Fitch and Moody's--became an exclusive club of NRSROs, or Nationally Recognized Statistical Rating Organizations. The designation, first established in 1975 by the SEC, eventually widened to encompass 10 firms, although the others have never gained competitive traction.
As a result of culture, path dependency and investment guidelines, the marketplace continues to rely on the big three. "The SEC unwittingly promoted an oligopoly, rather than designing a process of approval that would permit new entrants and more competition or alternative companies," says Michael Youngblood, a principal at Five Bridges Capital in Bethesda, Md.
Both U.S. and foreign regulators further entrenched the agencies' dominance by baking ratings into their rules. The Basel II Standardized Approach measures the adequacy of a bank's capital cushion. It assigns a capital charge to each asset, which is weighted according to its rating.
"It's ironic that, just as reforms were being proposed in 2008 to remove ratings from SEC regulations, the adoption of Basel II was pushing regulators in the opposite direction," Herring comments.
When companies are paying for their own bonds to be rated, the pressures toward grade inflation are obvious. To make matters worse, issuers pay maintenance fees for monitoring and re-rating, clearly undermining any impetus to downgrade and cloaking poor performance.
On Oct. 22, 2008, the Congressional Committee on Oversight and Government Reform held a hearing on the role of the credit rating agencies in the Wall Street crisis. In his opening statement, Chairman Henry Waxman (D-Calif.) referenced an October 2007 presentation by Moody's CEO Ray McDaniel: "Analysts and managing directors are continually pitched by bankers, issuers and investors," McDaniel told his Board of Directors in a confidential address, admitting that sometimes we "drank the Kool-Aid."
The problem is compounded when rating agencies are paid consulting fees to help design the structured finance deals in the first place. "Everyone is sitting on the same side of the table at that point," says Graham Henley, a director at global consultancy LECG and former director of mortgage-backed securitization at Soci?t? G?n?rale: "The fox is in the henhouse!"
Garbage In, Garbage Out
When models are based on erroneous or insufficient data, they produce misleading results. One of the stumbling blocks to rating securitized instruments was the dearth of long-term data for extrapolation. Although the ratings analysts assumed defaults would increase during an economic slowdown, recent history offered no such modeling data for innovations like CDO's.
Indeed, many CDO's were simply unratable on the basis of the home loan characteristics in the reshuffled pools of mortgages. In his testimony, Rep. Waxman refers to exchanges between S&P employees describing the pressure on analysts to devise shortcuts, based on guesswork, to come up with some rating--any rating at all. "It could be structured by cows, and we would rate it," one analyst wrote.
When the rating agencies addressed structured finance transactions, they relied on issuers' representations that the data submitted was accurate. If it were found to be false, the issuers were bound to buy back the loans. Yet those "reps & warranties" were not systematically tracked, according to Frank Raiter, a former managing director at S&P who testified with Waxman. Investors, too, made a leap of faith, notes John Maher of LECG's Secura Group in Vienna, Va. and formerly head of international strategic development at Fleet Bank. "They effectively outsourced the risk of a given investment, taking it on faith that the proprietary information was more sophisticated than they could achieve," he says.
Outdated models failed to capture the changes in performance of the nonprime products. In a period of rapidly rising house prices, the models could have presumed some long-run mean reversion and assessed credit enhancements accordingly. "They assumed static economic activity and implied that structured finance products should receive the same credit enhancements in, say December 2008 as in December 2006," says Youngblood. The same principle applies to all consumer product--whether mortgages, credit cards, auto or student loans.
The Bottom Line
The models incorporate fuzzy inputs and methodologies for all types of credit--not just securitized issues. George Strickland, managing director and head of municipal bond investing at Thornburg, laments that rating agencies still tend to put too much credence in projections for many types of projects such as those he covers, like the Las Vegas monorail or toll roads--which rarely measure up to optimistic traffic projections and revenue flows, and lead to cost overruns.
"Issuers hire consultants to produce reports, and consultants are paid to show numbers that work out," Strickland says. Rating agencies, likewise, don't get paid unless a deal actually happens, so they look at reports with rose-colored glasses"
Still, the really hefty fees flowed from the securitizations--especially CDO's. From 2002 to 2007, revenues at the three major rating agencies catapulted from $3 billion to more than $6 billion. Ultimately, about half of those billions came from structured debt. A culture directed to profit prevailed over analytical rigor. Jerome Fons, a former managing director for credit policy at Moody's, recalls how firm management's focus increasingly turned to maximizing revenues: "Managers who were considered good businessmen and women--not necessarily the best analysts--rose through the ranks."
The Commission has finally stepped into the breach to attempt to address the procedures, transparency and conflicts involved in rating--especially toxic securities. Last Dec. 3, it added some final amendments to an original, bold proposal of six months earlier. The December rules succeeded in mandating increased disclosure, and most important, prevented the agencies from rating deals they have structured--a key ban Herring warns may prove "unenforceable" and "difficult to police."
Meanwhile, however, the Commission appears to have pulled the teeth from the initial proposal of June 2008, which contained two other critical reforms: First, it suggested that the agencies differentiate between the risks of straightforward corporate bonds and those of mortgage-backed instruments. The latter, which are predicated on the payment streams of multiple mortgage holders, can be far more volatile.
The second June proposal, also rejected, was "the most revolutionary," Herring says. It proposed removing the use of ratings from all SEC regulations, which would have defrocked the hegemony of the NRSRO's. No longer would their ratings have enjoyed sanctified governmental status.
It seems unlikely the rating agencies will ever regain their former credibility without a thorough revision of their underwriting criteria and models. Yet both internal and external overhauls seem to be taking place episodically, with revisions rather than a clean sweep. Viva Hammer, a tax partner at Crowell & Moring in New York, does not mince words, preferring to "disintegrate [the ratings agencies] and get rid of them." At the same time, she has some sympathy for their impossible mission. "They carry the whole weight of the financial world on their shoulders, and are used as a shortcut for a snapshot of the health of the widest range of organizations imaginable. Is any institution capable of carrying that kind of burden?" she asks.
Alternative Due Diligence
Yet if we throw out rating agencies altogether, small investors in particular may have limited recourse to alternative analysis. Credit research is difficult and expensive, and only leading firms have a sufficiently deep bench to perform it expertly in-house.
Where can wealth managers and other sophisticated advisors turn? Among leading independent providers, several names stand out: CreditSights, Gimme Credit and KDP Investment Advisors offer research to the investment community, including mutual funds, hedge funds and advisors. Some of the smaller NRSRO's, like DBRS, Rapid Ratings and Egan Jones, have better recent track records. The latter two, for instance, contemplated a General Motors bankruptcy as far as several years back. Morningstar examines creditworthiness of issuers and collateral, while some research outfits focus on specific areas. Green Street Advisors covers REITs; Youngblood's company, Five Bridges Capital, surveys all debt and equity securities in mortgage and housing markets--including banks, thrifts and credit unions--both for top-down and bottom-up approaches.
Credit Default Swaps are another tool that managers can use to supplement credit ratings. James Genteman, director of Fixed Income at South Texas Money Management in San Antonio, regularly monitors corporate debt on Bloomberg for his clients' portfolios. "I check if spreads are widening, as an indication of the market's perception as to whether a given company poses any default risk," he explains. Noticing such spreads in late 2007, he prudently moved his clients out of MBIA, Ambac, Citigroup and Bear Stearns.
In addition to spreading their research among a broader base of sources, HNW planners should "demand regular updates on any adjustments to ratings," Henley suggests.
While all the additional due diligence activities take time and effort, they also provide wealth managers with a chance to prove their worth to clients. Poring over prospectuses and associated paperwork may not make for recreational reading, but it serves as a reminder to clients that you are vigilant about safeguarding their assets.
Vanessa Drucker, who used to practice law on Wall Street, wrote about the controversy over valuing assets in the January issue of Wealth Manager.