Saturday, May 3, 2008

Failures Of The Credit Risk Rating System

Back on April 17, Financial Times reported that Standard & Poor’s rating matrix showed the average default rate on AAA corporate bonds was more than four times greater on than on AAA structured credit. This was based on analyzing rolling three-year periods between 1978 and 2007. This news should have been sufficiently evident for the rating agencies to immediately begin overhauling the rating systems and making their rating process more transparent.

However, the news on Friday indicates that the rating agencies may not have learned their lesson, as Barbara Ridpath, European head of rating services at S&P, is quoted saying: “I stand by the ratings we have issued.”

How can you stand by the ratings when your own default study indicates otherwise? This is blatant ignorance of the fact. Further evidence of the arrogance and ignorance of their failings is provided by Frederic Drevon, EMEA head of Moody’s Investors Service, who is quoted saying: “We did not make it sufficiently clear to the market as to how a rating should be used. Many investors were using ratings as a proxy for market prices, which is not an appropriate use. Ratings are an opinion of the credit risk, not the liquidity risk of a credit instrument.”

Mr. Drevon’s statement misses the mark, which is that the market will add on additional yield on the credit security, if the credit rating system cannot be trusted. This affects liquidity as the holder of the security will now not want to sell at a loss and potential buyers will not want to pay the face value.

Furthermore, if Mr. Drevon believed that the market did not fully understand how the ratings should be used, then why not proactively go out there and educate the market? Why plan on doing it now? If the rating agencies indeed did go out and educate the market, then why is the market still not using the rating correctly? I cannot buy Mr. Drevon’s argument at face value and must take a credit risk option against it.

Another evidence of the failing of the rating agencies comes from the Attorney General Richard Blumenthal of the State of Connecticut who stated, in his March 2008 statement before the house committee on financial services, that:

“The major credit rating agencies own studies show --beyond any doubt --that default rates for municipal bonds are substantially lower than identically rated corporate bonds. Moody's study shows that higher rated Aaa corporate bonds are four times more likely to default than lower rated Baa municipal bonds --a rating seven notches lower than Aaa. Indeed, a 2006 Moody's report revealed that the top five municipal bond grades, Aaa through A1, would all be rated Aaa if they were corporate bonds. These default studies make clear that Moody's employs two distinct rating scales for municipal bonds and corporate bonds. Fitch published default studies in 1999 and 2003 that showed similarly low default rates for municipal debt.”

Now the rating agencies are busy cleaning house and trying to impose a form of self-governance to keep the government from regulating them. The question that investors should be asking is why didn’t the rating agencies have strong self-governance system in place and if they did, then why did it fail?

However, from current quotes, it is evident that the self-governance and cleaning house that the rating agencies are doing right now will amount to nothing more than a few dusting of the ratings definition, replacing numerical systems with alphabetical, or vice versa. In the end, it will take a lot for the rating agencies to regain the trust of the market.

Potential Corrective Actions For the Rating Agencies
Establish a private governing body similar to FINRA to regulate and monitor the rating agencies. Funding for this monitoring entity would come from a portion of the ratings fees. This way, the rating agencies can maintain their self-governance with minimal governmental regulations.

Have an independent third party annually review the rating agencies’ rating procedure and process and make this report public. The market will then have the ability to comment on the findings, providing a check-and-balance system.

Have a great weekend!

Ed Kim
Practical Risk Manager

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