Saturday, July 19, 2008

Rating Agencies' Value To The Market? Nada, According To Their Disclosures

With the unraveling of the credit market, one has to wonder what value had the rating agencies actually provided to the investors. It appears quite obvious, in hindsight, that the rating agencies’ values were all perception and not reality. After all, why are financial institutions so busy marking down even “AAA” rated bonds and taking ever-increasing loss reserves against them?

If one read the typical disclosure that is on a rating agency rating letter, one would quickly realize that there is no real value. In fact, the rating agencies’ disclosures would read something like this:

Ratings are based upon information that we consider to be reliable, but neither [Rating Agency] nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Rating agencies do not perform due diligence and assume the accuracy of the information that is provided to them by issuers and their advisors. Neither [Rating Agency] nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. This material is not intended as an offer or solicitation from the purchase or sale of any security or other financial instrument. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

(Note: the above is not an actual disclosure from any one rating agency; however, if one looks at S&P and Fitch Ratings, one would see where I had obtained the above language.)

The rating agencies are on the hot seat, again, for their contribution in the current financial downturn. They were here before in 2002, with their corporate credit ratings of Enron: (S&P response to SEC; Fitch Ratings response to SEC; and Moody’s response to SEC). The rating agencies’ argument now is the same as it was then: they are not in any conflict of interest and the ratings they provide is beneficial to the market and is simply an opinion protected by the first amendment and not bound by Regulation FD.

Government Is Forced To Act, Again
Again, the market has forced the government to react. Most recently, the SEC released their examination report of the rating agency and found the following issues, among others:
1. Significant Aspects of the Ratings Process Were Not Always Disclosed
2. Policies and Procedures for Rating RMBS and CDOs Can be Better Documented
3. Rating Agencies are Implementing New Practices with Respect to the Information Provided to Them
4. Rating Agencies Did Not Always Document Significant Steps in the Ratings Process
5. Rating Agencies Did Not Always Document the Rationale for Deviations From Their Models
6. Rating Agencies Did Not Always Document Significant Participants in the Ratings Process Rating
7. Rating Agencies Did Not Always Document Committee Actions and Decisions
8. Issues Identified in the Management of Conflicts of Interest

Truly no surprises here, especially to those who have been following this circus act of “slap the rating agencies on the wrist.” The Investment Company Institute (ICI), the national association of U.S. investment companies, has been lobbying the government to improve its oversight of the rating agencies for over 20 years. Here are the ICI’s comment letters to the SEC on regulation of the rating agencies: 1998 comment letter, 2002 testimony, and 2003 comment letter.

If the SEC had listen to ICI then or even listen to Senator Joe Lieberman in 2002, perhaps things may have turned out a bit better. Perhaps the combined efforts of the EU (European Union) and SEC might finally provide enough momentum in tightening up the supervision and accountability of the rating agencies. Or, perhaps not.

It may be a while before any truly innovative accountability and supervision are placed on the rating agencies. Until then, let’s not forget what we all learned in business 101: “Caveat Emptor.” After all, the rating agencies are simply stating that their ratings are simply their opinions based on information given to them that they assume is correct.

Let the rating agencies hide behind the first amendment; they have the right, just as supermarket tabloids like the National Enquirer.

Ed Kim
Practical Risk Manager

Disclosure: Ed Kim was formerly a rating analyst with Fitch Ratings in the late 1990’s, responsible for performing credit rating and due diligence on several CMBS and FASIT transactions.

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