Portugal’s Finance Minister Blames Ratings Agencies
Fernando Teixeira dos Santos, Portugal’s finance minister was critical of the international credit rating agencies for damaging his country’s economy. He is saying that the risk assessments being made are mistaken.
The Financial Times reports him saying, “Many of the problems we face are related to errors in risk evaluation that have been made, in part, by the rating agencies… We cannot be subject to the commercial strategies [of rating agencies] whose objective may be to increase their market share.”
He went on to say that it was “paradoxical” that the rating agencies (and others in the banking and business communities) had appealed to governments to support economies at the height of the global crisis. Now, however, these same players are insisting that states rapidly consolidate their deficits.
Three credit rating agencies have recently warned that Portugal’s sovereign debt faces downgrading if it should fail to take steps to lower its budget deficit. That deficit is now at a record 9.3 per cent of gross domestic product in 2009. In contrast, the U.S. 2009 deficit is projected to be 12.4%. of GDP.
Portugal’s long-term debt rating currently ranges from Aa2 at Moody’s to A+ at Standard & Poor’s. Spain and Greece’s credit ratings have also been threatened by their respective deficits forced by the worldwide economic conditions.
A Good Idea
Representative Paul Kanjorski D-PA has proposed that the federal rule be dropped that requires credit ratings to determine what an asset is worth, and therefore determine capitalization. Representative Kanjorski’s intent is to distance the Federal Government from a de facto endorsement of ratings agencies’ work. In its own right, this is a worthy goal.
But dropping this rule, which dates from the Great Depression would have a far greater consequence. The unanswered question is: What will replace NRSRO ratings.
Although a good move, this rule change is still nibbling around the edges of the reform that’s needed at the ratings agencies. Until the business model is changed so securities issuers are no longer paying for their own ratings, the value of those ratings will be forever suspect.
Mission Impossible
The unworkable environment in which ratings agencies function is slowly coming to light.
It was discovered that while Goldman Sachs was selling $40 billion in securities in 2006 and 2007, backed by at least 200,000 risky home mortgages, they were secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting.
Goldman Sachs maintains that they were merely managing risk and had no disclosure burden under the Securities Act of 1933. Maybe so, maybe not. That is for the lawyers and courts to decide.
Nonetheless, it gives one pause when putting this issue into the context of a rating agency. How incredibly difficult it must be to assess a security given the initial paucity of information, the underwriter’s efforts to keep as much information buried as possible, and the pressure from the rating agency’s internal organization (tacit if not overt) to give clients high ratings.
For rating agencies to be effective again, they need greater access to information, they need to be free of conflicts of interest, and they need regulation to ensure they get both.
The Time To Act Is Now
There is plenty of blame to go around for the bond rating problems, and some hard decisions need to be made to ensure the problems we have today with multi-obligor bonds never happen again.
Although it is wrong to hold the ratings agencies entirely culpable, that is probably where most of the changes need to take place. The agencies need the tools, both the analytic models and the rating convention, to accurately assess the risk and value of a multi-obligor bond.
In many respects, we need the ratings agencies to protect us from ourselves — from our rosy outlooks, our sloppy investment research, our distractions, our peccadilloes. We desperately need them to be able to do a good job.
The real catastrophe will be if the industry is unable to fix these deficits ourselves. So we need to act now. If the government fills the void with more regulation and more bureaucracy, it may be decades before we can again enjoy the growth and success we enjoyed before the fall.
We Need To Retain Control
There is a wide degree of agreement that the rating system needs to be changed. The hope would be for the industry to create a well-funded, not-for-profit, independent organization to self-regulate the industry whose opinions would be beyond reproach, like the MSRB for the municipal market.
A truly frightening alternative is that the federal government would create its own rating agency. We can only imagine the bureaucratic muddle that would ensue. Or almost as frightening is the prospect of new regulations governing — and hampering — the current ratings agencies.
We as an industry need to accept responsibility for creating the problems we have today, but the solutions we would affect would be far better than anything imposed by Congress. But we need to quickly demonstrate a commitment to change to retain control of our business.
Congressional Hearing – Credit Rating Agency
Below is the summary and discussion draft for the Congressional hearing that will be held on September 30, 2009.
See section 7
Section-By-Section Credit Rating Agency Summary
Credit Rating Agency Discussion Draft
Goodbye, Ratings?
On CNBC two weeks ago, Congressman Barney Frank proposed to do away with bond ratings. At the time, it seemed like posturing.
Then it was announced that there will be a hearing for a Banking Sub-committee on September 30th. Among the listed discussion points are a full section on the removal of ratings from statutory references, as well as a draft bill.
The unintended consequences of this action are monumental. It seems impossible to “de-certify” NRSROs and remove ratings from the financial architecture altogether. Ratings are pervasive in the U.S. financial system from banking to insurance, from trust agreements to collateral agreements and investment policies. It is unimaginable to delete their usage.
Banking and Insurance regulators use ratings to evaluate credit quality. So my first question is, “What do the regulators think?”
I think trashing the ratings system seems extreme.
It seems to work for single-obligor securities.
Where the problem lies is in multi-obligor securities.
Let’s enhance and improve ratings for multi-obligor securities.
Let’s recognize what a rating reflects: the probability of default.
The rating is silent on the magnitude of loss.
The 100-year-old ratings system was never able to handle the multi-obligor nature of modern securitization. The inherent flaw in the system was only noticed when housing assets began to depreciate.
Securitization allows for the creation of credit, which enables our modern economy to function. We need to enhance ratings, not eliminate them. In the coming days, we’ll need to watch the hearings closely.
Please watch the video of Congressman Frank’s CNBC interview on 9-21-2009 where he initially put forth these projections:
The Government Is The Only Quick Way To Restore Faith
The implications of inaccurate bond ratings are enormous and will take decades, maybe generations to sort out. But the problem lies deeper than with the rating system.
Investors have lost faith in their paper. At the simplest level they agreed to loan money using a multi-obligor bond as a security. The investor does his due diligence and sees that the bond is rated as a safe investment by a credit risk agency. Then a while later the bond is downgraded and the investor is exposed to more risk than was agreed and a whole set of problems ensue for the investor: under-capitalization, devaluing of the bond, greater risk profile, etc.
But the worst is that the credibility of the issuer and the rating agency are made suspect. The fundamental trust upon which our financial system is based is compromised.
So how do we restore trust? The leap of faith that is integral to any business transaction now needs to be backed by a neutral third party.
Unfortunately the only entity large enough and with sufficient standing to back trillions in possibly toxic assets is the US government — not someone with whom you want to do business. But, do we have a choice?
One Bond, Many Obligors, So Where’s The Risk?
Intuitively you know that a multi-obligor security is a safer investment than a single-obligor. The risk of complete default is spread across hundreds of debtors, not just one. If one obligor fails, there are many others who are performing as agreed. Your loss is nominal.
Even if 15% of obligors flounder (which, on a nationwide average, is about the worst failure rate for home mortgages) you still have 85% performing. And in the case of bundled home mortgages or car loans, the foreclosed homes or reposed cars still have value. Not market value perhaps, but it is greater than zero. So in the worst case you haven’t even lost 15% of your investment.
So, why are multi-obligor securities being downgraded so ruthlessly?
It appears as though the issuers and ratings agencies have no clear idea what is in the multi-obligor bonds they respectively issued and rated. Hence they are downgrading the bonds to a point at which they are comfortable not knowing what is included in the multi-obligor bond. Their abundance of caution — now when it is too late — is causing a lot of pain for a lot of good people.
The Department of the Treasury Gets It
The Department of the Treasury released an 89-page “white paper” on June 30, which has since been updated on August 11. As we understand it, this is an administration paper. The section on regulatory reform is puzzling only because we are curious about who put it in there.
This section provides an exact and explicit distinction between single- and multiple-obligor securities. It tells credit ratings agencies to differentiate between single and multiple obligors, and fully disclose what the ratings mean/measure. It also instructs regulators to “reduce their use of credit ratings in regulations and supervisory practices” and to “recognize the potential differences in performance” between structured and unstructured products.
As you can imagine, we endorse the principles in this section.
