Less than sterling performances by credit ratings agencies during the debt crisis increased pressure for the EU to act. In March the new CRA watchdog, the European Securities and Markets Authority, completed its first review of the big three: Moody’s, Standard & Poor’s and Fitch. Several areas of improvement were identified but will the review lead to restoration of confidence in ratings?
To view the digital version of this report, please click here.
ESMA’s review of the big three identified several shortcomings and areas of improvement in the ratings of sovereign debt, banks and covered bonds. The findings were hardly surprising to critics who have long questioned the relevance of CRAs in SSA analysis and raised renewed relevance concerns, but may also enhance ratings transparency and restore some confidence in the SSA ratings process.
The relevance question typically resurfaces following both poor performances by the agencies and misperceptions of their role in the financial markets. In a February 2012 testimony to the US House of Representatives, a senior Moody’s executive, Richard Cantor, said: “… at the time Moody’s forms its credit opinion about any bond, it is not yet known whether the bond will perform or default”.
This reveals the frustration often felt by CRAs when market participants and lawmakers consider ratings not as relative measures of credit risk but as absolute predictors of default. Misapplications of ratings combined with CRA shortcomings are perhaps the two most important contributors to the diminished confidence in external credit ratings.
The continued use of credit ratings by investors, issuers and governments is, however, recognition of the importance of third-party credit opinions in the functioning of the financial markets. The question of their relevance seems therefore rather ill-posed. How to render CRA opinions truly independent, transparent and reliable has been the task of Michel Barnier, the EU commissioner in charge of regulations. He faced stiff opposition from other EU finance ministers, MEPs and the UK financial services industry on his proposal for SSA issuers to rotate CRAs or the proposal to ban ratings of SSAs in crisis or in EU bailout programmes. However, ESMA appears to have embarked on decisive steps to render SSA credit ratings and the companies that issue them more relevant to the global financial system.
Modus operandi
Myths and clichés often surround the role of CRAs in assessing SSA debt – ultimately it is a technical enterprise intended to be apolitical. The major agencies have similarly detailed methodology publications which, at their core, represent opinions about the relative creditworthiness of SSAs. The methodologies indicate that sovereign ratings are not designed for public consumption or to be deployed by politicians for patriotic or jingoistic ends, neither are they intended as triggers for liquidation actions that can cause sharp sell-offs and contagion as investors exit the SSA market.
So how should SSA ratings be used? Simply, they should form one component of an investor’s arsenal of tools to analyse an SSA’s claims-paying ability. They should not be the only component; neither should internal ratings be relied upon exclusively as they may suffer from limited access by the rater to key figures in the rated SSA. Smaller investors may lack the necessary systems, processes and personnel to adequately assess SSA risk in complete independence of external CRAs. Inadequate internal expertise and excessive reliance on external credit ratings were important factors in the mispricings and sell-offs that accompanied the sovereign debt crisis.
Lack of transparency
Panics and sell-offs are often exacerbated by the kind of uncertainty that ratings opacity engenders. The SSA ratings process, outcome and dissemination of information have not always been transparent. The agencies do not systematically record central aspects of the process such as the dispersion of votes within ratings committees and the rationale for ratings decisions, particularly those that differ from the recommendations of lead analysts.
Even before these all-important ratings committees, the process of selecting attendees, delineating voting and non-voting members, and the time allowed to analyse committee memoranda are typically not formalised. The danger is that at times of crises, SSA ratings committees risk attracting disproportionate numbers of voting members with neither the time nor the expertise to analyse voluminous committee material submitted with a few hours’ notice. Decisions taken by such committees may not be well-reasoned or clearly communicated, potentially sowing or magnifying market panics.
High staff turnover is another feature of the CRA business model that does not bestow confidence in the ratings process. In the aftermath of a crisis, senior management is often tempted to overreact and scale back on resources and personnel in the affected lines of business. However, ratings integrity is undermined by lack of resources and the inexperience of newer employees who may need time to familiarise themselves with the asset class and the agency’s internal processes.
The varied definitions of sovereign defaults by the different agencies was another source of confusion for an SSA market already smarting from sharp sell-offs. In addition, by withholding details of the quantitative models employed in the ratings process – inputs, outputs, stress test parameters and results – the transparency and reliability of the ratings process were not greatly enhanced.
Despite these and other hiccups identified by ESMA in its review of CRAs, third-party SSA credit opinions play a crucial role in the financial system and are used by a wide range of market participants. SSAs are responsible for more than 60% of total annual debt issuance globally. As mentioned above, external ratings combined with internal assessments can provide a more comprehensive measure of the creditworthiness of SSA issuers.
Legislative steps
In recognition of the importance of CRAs in the functioning of the financial markets, the EU has taken important legislative steps to ensure more transparency and reliability of the ratings process. The March 2012 publication of ESMA’s review of CRA personnel, processes and systems for rating sovereign debt, banks and covered bond found several shortcomings and areas of improvement.
ESMA has addressed specific recommendations to each of the big three agencies and will follow up later this year. The watchdog’s powers range from registration to monitoring and sanctioning of offending agencies through fines, including suspensions or deregistration. The SSA market will be watching the impact of these legislative changes and regulatory powers with keen interest. The hope will be that they enhance transparency, understanding, reliability and the proper use of credit ratings.
Henry Tabe is chief risk officer of Sequoia Investment Management Company, He is a former MD at Moody’s and the author of “The Unravelling of Structured Investment Vehicles: How Liquidity Leaked Through SIVs”.
