IFR: If it is more a question of track record, to what extent could unsolicited ratings be used to establish this?
Ganguin: They have been used in the market to establish a platform and a track record, and it has been something of a hot debate in the US as to whether they were going to favour unsolicited ratings or not and the extent to which unsolicited ratings are used in a non-predatory way but more to establish a track record. This is something that all rating agencies have done to enter a new asset class or to create competition, to create an alternative view of the world. At Standard & Poors we actually welcome competition from that standpoint.
At the same time, the market should decide whether the track record is justified, in that it takes a long time to establish one. The requirements under Basel II for banks to be eligible for an IRB [internal ratings-based] approach dictate that they have to have a long-standing track record to be considered for that certification. So it is the same thing for rating agencies. You need to be able to establish a long-term track record to be relevant and useful to the market.
Hunter: It is an interesting point, looking at Basel II, because in fact Basel requires banks to have more data and is actually far more lenient on the rating agencies, in that if you are a rating agency that sets itself up today you clearly would not have 10 or 15 years' worth of default data you could actually submit. If the local supervisor really wants to encourage and promote competition, it can actually accept that under the Basel guidelines the data requirements for the rating agencies are generally much lower than they are for the average commercial bank, which is fair, because a commercial bank will typically have vastly more data than the largest of the ratings agencies.
But it is interesting that, even with that essentially lower threshold, we have not seen a significant number of new rating agency entrants. There have been national markets where it has happened for a local rating agency, and we understand in the context of Europe there will be a few more local agencies that will gain recognition. It is a market that has, on the face of it, very high margins and that should attract an awful lot of new entrants. The experience in Germany was that there was a lot of expectation that it would be a market crying out for competition, an economy theoretically open to competition in ratings, but successful attempts to establish local German rating agencies have met with very, very modest success.
It is an interesting dynamic because for many years I have been going to events where people have talked about the probable need more competition in rating agencies but it has essentially proved a much more difficult thing to achieve.
Liehr: If there is ever going to be competition it has to be driven by investors. When we talk to issuers, they are always complaining about the high fees, but not many complain about methodology and lack of transparency. I think both the major agencies have made a lot of efforts, so I think the ratings are pretty clearly explained, and when you compare them you feel it is not that much of a difference: it is maybe on average half a notch or even less than that.
When we talk to syndication departments and investors the message is very clear: they are quite happy with the ratings they get, with S&P and Moody's in general, and I do not think they can really see a lot of added value coming from Fitch unless it is confirming the opinion of one of the other agencies, where you have a split rating. Otherwise, investors just look at the rating, they know that these agencies know what they are doing, and they go with them. That is unless they look through the whole research report for a company and look in-depth at the methodology, but there are very few investors who actually make that effort.
Although Fitch has a very good standing with investors, I am not sure they would rely on a Fitch rating or whether they are just flattering you and saying: your methodology makes a lot of sense, we like your research pieces, but ultimately we would only ask for a Fitch rating if we really feel there is value added, and, to me, that has not been happening so far.
Hunter: I think we are being slightly pessimistic, on the possibilities for new entrants. It is very difficult, but we certainly feel we have achieved it. If you look at one very strong area of investment such as bonds, which was a closed shop to us for very many years, our breaking in is not something imposed by a regulator, some well-meaning politician or a cartel authority: it is a voluntary decision undertaken by investors based not on one individual situation, but based on the fact that if we are in the index they have to pay attention to what we say. There is a flip-side of this, which is: can you have too much competition? You can argue, on the fee side, that you could never have too much competition, but is it practical for an investor to look at a bond index that tracks what has happened with seven or eight different rating agencies? Could that actually make the process more complicated rather than easier?
But I am not certain that we are being flattered by investors. We have made a lot of effort with investors in the past few years and we have certainly had a positive response, so I am not sure an inclusion in the bond indices is entirely an act of flattery.
Madelain: One has to be careful not to have too narrow a scope when looking at the structure of the industry, because effectively we provide a product or service where there’s lots of competition. It may not come from rating agencies, but there are people that are effectively providing similar information, and that competitive thread has been increasing over time with technology: we could see that having an even stronger impact on our industry. That is why we are investing as heavily as others in analytics, amongst other things, because we are not complacent. We know that there is an alternative source of information to the service we provide. Investors have the choice and, therefore, if they are not satisfied with the service they are getting, they will go and look at the alternatives. So, I think that wider scope provides a slightly different perspective.
Liehr: Where do you see sources of dissatisfaction?
Madelain: We have seen all the agencies effectively offer such products, but now we see non-rating agency products being offered. In certain asset classes they are competing with our analytics and they are providing effectively what a rating provides.
Ganguin: And investment banks have their own systems.
Madelain: So there is a wide range of tools that are increasingly becoming available and that effectively are part of the competitive landscape that we need to factor in.
Theodore: I think that this is a very good point, because the mere fact that the large rating agency services are focused more on possible competition has a positive effect. If the world knew that there were only two rating agencies in the market and that was going to be the situation for the next 20 years, I am not sure that these agencies would have the incentive to diversify to cater for investors and issuers. But the mere fact that the competition does exist, or it is building up, is a positive element for everybody in the market, be it large rating agency or upstart.
For us, for example, we go to people, to investors, and we say: "Well, here we are, new kid on the block: what do you think our chances are?" and people say, "Well, you know what, we have three ratings, it is not so much that we need a fourth rating – yes, that would be nice if we had it – but if you can bring something that we do not get from our existing providers of ratings services, if you add value there, of course you can do it".
It is not only the rating itself but it is the service; the analysis, the dialogue with issuers, the dialogue with investors, the position that we take in the market that is important.
Madelain: If you look five years ago, there were more agencies than there are today, so I do not think that pressure, or the development of new technology or new product is actually driven by the number of agencies. I think it is driven by the increasing demands of the marketplace and the fact that there is a need, and in this context, the agencies see a role for themselves to play in the market.
Aucutt: From an issuer’s perspective, if I am looking at structured finance and even plain vanilla RMBS, I am not going to be that keen on having even more ratings, necessarily, as I will end up with pages and pages of my offering circular full of different criteria where there is little difference. There is going to be a natural limit to what I am going to want to have, otherwise I am going to have the poor guys on the analytics side running the pools tearing their hair out trying to meet the criteria.
Hawley: As far as competition goes, you want more players in the game, but do you want to have five Triple A ratings, all slightly different? I do not think so. What we are hearing is that competition is actually trying to bring about new products and services, but for me as an issuer, competition is interesting. This is not a public market with lots of private individuals who need competition to bring about price reduction: we are talking about four rating agencies that are facing issuers and investors who are fairly complex animals themselves and are able to look after themselves in that world.
So I think what we are looking for is that there is sufficient robustness and transparency, and that we can hold rating agencies to account if we feel that they are wrong. I think that does happen. It has happened recently.
IFR: And just how transparent is the process?
Hawley: It could be better done, better delivered. It is about the transparency of the process and also the deliverer, and rating agencies need to consider that what they say and does have an impact on the market.
IFR: To what extent do you think, going into Basel II, that rating agencies are taking on the role of regulators, or does there seem to be something of a meshing of the two roles there? Do you think that is something that could be a potential problem for rating agencies?
Hawley: It could: I think it depends on where the rating agencies want to position themselves. Basel II lays down fairly clear guidelines about how companies are expected to rate and it is on a standardised approach that we rely very heavily on models. You would have the power then to challenge what has been said about you.
It is a grey area at the moment. We will have to wait and see how it develops but I think there is potential there for the rating agencies though they will have to tread very carefully.
Theodore: As far as Basel II is concerned, everybody is talking about transparency. Sooner or later banks will need to deal with the Third Pillar. Right now it is on the back-burner, but not for long, I hope.
When you get involvement in the Third Pillar, then the degree of transparency will increase tremendously, from what I am told. So, to that extent, the rating agency needs to mirror what is going on in the market and look at more information in a more transparent way. At least the market can encourage the rating agencies to be more transparent themselves, but right now transparency seems to be the buzz word and I am not convinced that is the only solution to the challenge. You can have the most transparent analytical process and methodology in the world and behind the transparency you see a logic with which you may disagree. So you may have a perfectly transparent methodology which would not sell to the market. This is another challenge that not too many people are talking about: the fact that sometimes methodologies being fully transparent and fully responsive to current needs in the market do not offer the logical solution for long-term ratings. Again, that is another argument for why one would like to see more competition. At least up until now, rating agencies, perhaps unlike other businesses, have been talking past each other, and it is perhaps time to start talking more with each other, to have an open debate among rating agencies and users of ratings, issuers and investors, about methodologies, about a correlation of methodologies on long-term ratings. If that process takes place, then, of course, it needs to be a competitive process where the competitors will not only be other rating agencies and new entrants, but issuers and investors.
Ganguin: What you are suggesting is a very difficult process, because essentially the only true metrics that exist in the credit markets are around default: that is 1 or 0, it is still binary. The rest is interpretation, it is the transition matrices, everything that is a subset of the ratings world. How the structured finance world operates is an interpretation of ratings and there is no control group for that. The only control group we have is default – in other words, whether an entity goes into default or not.
Theodore: It is a matter of credibility. The market commercially has seen precious few defaults, at least in fundamental ratings, investment grade ratings. But at the same time the rating analyst is paid, not only to reflect the equation of the fact that this company or that is likely to default, but to go beyond it and ask: what are the factors that could trigger default ? I think, if the market is then going to buy into these factors, the agency or the analyst needs to have credibility in the market. So, if ‘X’ says so, then the chances are that scenario would happen. But if ‘Y’ says so, it is not as well trusted; people will not want to spend too much time looking at its analysis.
Again, that comes back to the credibility of the rating agencies’ own track record, which has so far been impressive.
IFR: Could transparency count against you in that you could just be viewed as being transparently wrong?
Theodore: You could be transparently wrong, and it has happened in the past, absolutely: it is a fact of life. So behind the transparency process you need to have a solid logical analysis and, again, that is a big question because of the scarce number of defaults.
IFR: We mentioned an increasing view of rating agencies as de facto regulators. The phrase sometimes used is ‘power without responsibility’: is that valid? Ultimately, the regulator is someone who is paid by the taxpayer and the rating agencies are commercial entities. Obviously they are there to please their shareholders.
Ganguin: But this is nothing new. I started my career in Canada, where we were the new entrant. We were the new kid on the block and DBRS was the big guy there. If you look at the CP market in Canada, it is basically all built with reference to DBRS ratings, and that is accepted.
That is just one illustration to show that everywhere in the world there are a lot of prudential measures which are built into investment guidelines of pension funds, mutual funds and generally in the market. Structured finance is probably the best example, where the rating agencies play a quasi-regulatory role, whether they like it or not. Basically it is built into the system and the regulators rely on that, to a degree, as well.
So I do not think it is a new evolution, I think what is new is the fact that ratings have gained an increased importance. As we mentioned earlier, when we first started ratings in Europe about 10 years ago, people had little idea about exactly what ratings were, whereas now it is an important world and it is accepted as that, although I do not think it is a particularly new reality that ratings are part of the regulatory landscape.
Kent Kershaw: But, that still does not address the question that you are a commercial organisation, you are not regulators. Who regulates the regulators? Who polices the regulators?
Theodore: The market.
Ganguin: Yes, the market. We have to keep in mind that ratings are opinions.
Kent Kershaw: But they are opinions that can have a huge financial impact. It was the rating agencies that sparked the market disruption of May 2005 and the subsequent plunge and the big test of the CDS market. It was the rating agencies that sparked that because of their downgrading of the autos.
Whether the underlying decision on the autos was right or wrong, the point is that a decision by a rating agency taken very quickly, can have an enormous impact on the market, and literally cost millions and millions of pounds. A lot of hedge funds suffered significantly as a result of that.
Madelain: But that is very different from saying that we are regulators.
Kent Kershaw: But you can still have a huge impact.
Madelain: So the question is: are we even aware that we are responsible for this impact?
Kent Kershaw: Exactly, and if you are not, what are the consequences, and who is there to ensure that you relay decisions in an appropriate way?
Madelain: I think there has been a lot of discussion, and I think the conclusion from this process has been that a combination of market discipline and industry self-regulation are probably the best way to address this concern, rather than some form of regulation.
Hunter: It is understandable that, because of the impacts the ratings can have, there is a desire to say there should be some means to recourse. It can be that an event happens on which the rating agencies have opined. It might even be an event that rating agency action has caused. The problem is that we do not design our ratings to meet a regulatory purpose, we design them to meet the purpose of bringing opinions to the broader public.
If the rating agencies were not there, if we just imagine that we were all expunged from the face of the earth, and the regulators had to find some other source to say, "we cannot just let charities go out and invest all their money in everything, so we would like to have some minimum threshold", you would end up coming back to something that looked like a rating agency. You will not find anybody, amongst the financial regulators, who is enthusiastic for that task, partly through a qualification concern and partly through the moral hazard concern. It is not an oversight role that anybody could be reasonably expected to perform.
After all the consultations what has been agreed on is that the least you can expect of agencies is that the procedure by which they reach an opinion is a rational and consistent one, and a lot has been done in the last two or three years to get that procedure more publicly understood, to get it out in the public domain and make it more consistent. But the idea of who rates the raters inevitably comes back to the complaint that they did something we did not agree with and something should happen to them.
Click here for Part three of the Roundtable.