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.

Ratings Agencies Relied On Bad Information from Freddie Mac and Fannie Mae

Peter Wallison, a Treasury Official in the Reagan administration, wrote in The Wall Street Journal that Edward Pinto, former Fannie Mae credit manager, discovered that both Fannie Mae and Freddy Mac routinely exaggerated the quality of its mortgages. Mr. Pinto explains that Alt A and subprime mortgages were routinely rated as “prime” to make mortgage credit more readily available to lower income levels.

Because of this misrepresentation, the ratings agencies believed that losses from the securities backed by these mortgages would be “within the historical range for the number of high-risk loans known to be outstanding.” Instead the number of high-risk loans was much larger than anyone knew. When the default rates and losses exploded, Mr. Wallison explains, the subterfuge was exposed, leaving those holding the assets — and the ratings agencies — wondering what happened.

Therefore, the fault for the collapse, Mr. Wallison maintains, was not Wall Street’s or the ratings agencies’, but the misreporting that distorted the perception of everyone who bought and sold securities backed by these mortgages. This misreporting, he believes, was in response to government affordable housing rules. “Fannie Mae and Freddie Mac are inexorably intertwined in the market collapse. It is essential that any examination of the crisis begin with a review of Congress’s use of Fannie Mae and Freddie Mac. We won’t hold our breath.”

S&P President Pushes to Drop Ratings Requirements

Deven Sharma, President of Standard & Poors, has argued for the repeal of regulations that require banks, public pensions, money market funds, and other regulated investors to hold debt evaluated by Nationally Recognized Statistical Rating Organizations (NRSROs). Standard & Poors is one of ten NRSROs, and these regulations originated in legislation following the Great Depression and have existed essentially unchanged for nearly 80 years.

The intent in the ‘30s was to prevent banks from risking their capital in highly speculative investments. The Federal Deposit Insurance Corporation (FDIC) was formed at the same time, and the regulation was, in part, intended to avoid exposing the FDIC to extraordinary risk.

Mr. Sharma speculates that, “rating mandates may have prompted some investors to use ratings in ways they were never intended.” Investors, he suggests, are confused, as they believe that NRSRO ratings are a “government seal of approval” and a short cut for evaluating an investment risk profile. Instead, Mr. Sharma maintains, the ratings should be use as only one of many tools that investors can use to analyze risk. “Hear, hear. Let’s have investors do their own due diligence.”

Instead of requiring regulated investors to hold NRSRO-rated instruments, Mr Sharma believes that the market should determine whether their assessments are used. “Our most important audience will remain the marketplace. If our ratings are valuable, people will use them. If not, market participants should not be forced to use them.”

Back to the Drawing Board…Why?

The S.E.C. seems to be going back to the same old regulatory structure. Last year, money market funds showed stress, and the US government prevented the funds from breaking the buck.

In the future, don’t we want investors to bear the cost of their own decisions? Do we want the government to remove moral hazard? If you invest, isn’t there any “caveat emptor”?

The Journal takes the SEC to task. Is this what the SEC  really meant to do?

[$$]The SEC v. Investors – WSJ.com, February 3, 2010

NAIC Saves Capital

Well, they got it done.

The National Association of Insurance Commissioners saved an approximately $5B in industry capital by ignoring the NRSRO ratings and using a recognized 3^rd party to evaluate mortgage backed securities. The NAIC understood that the rating only described the first dollar of loss, not the magnitude of loss, and that strict use of ratings would unnecessarily drain precious capital out of the industry at exactly when they could least afford it.

PIMCO was interviewed and hired,  and they subsequently evaluated thousands of CUSIPs to make the MBS valuations for the industry before year end. This independent, third party, global,  fixed income  institution was employed to make valuations impartially and consistently across the industry.

Three cheers in the New Year for the NAIC. This is a textbook example of regulators using market resources to make regulation fair, appropriate and realistic.

Insurance Rule Adds Up to $5 Billion – WSJ.com, January 4, 2010

Is the Tide Turning?

While not directly related to ratings, which is the main topic of this blog, the article below discusses a key related issue:  capital shortages at banks and their drag on lending.  A revamp of the ratings system could actually help address this problem because a carefully crafted restructuring of the way securities are rated and a corresponding restructuring of how regulators use these ratings would increase regulatory capital at institutions.  How?  Under the current system, securities that are rated below investment grade are treated as entirely toxic and drain capital from the banks that own them.  In many cases, only a small portion of these securities has been deemed uncollectible and therefore the entire security is not actually toxic.  Designed correctly, a new ratings system and cohesive regulatory framework would treat only the portion of assets at risk of loss as “toxic” and therefore would not punish a bank’s capital levels for the collectible portion.  The result would be a more accurate, reflective calculation of capital that would also increase capital at many banks as it relates to multi-obligor securities.

In the meantime, we can draw some solace from the fact that the White House is at least communicating that they are listening and are aware of the challenges imposed on banks that are keeping them from lending.  The flipside is that at least up to this point it appears the White House has very little practical influence on regulators, who have a different point of view.

Obama Pledges Support for Small Banks to Spur Lending – Bloomberg.com, December 23, 2009

Will New Ratings Reforms Be Effective?

The attached article talks about how the House recently made extensive progress towards eliminating all language from both laws and financial regulation rules that references rating agencies (NRSROs).  The “system” will no longer depend on such agencies.  These are the first steps of progress towards reform and are commendable.  However, the real wood that needs to be chopped is determining what the new system will look like when it no longer relies on the agencies.  This new system must consider many factors, but to ultimately be effective it must lead us to an economic value attached to the assets that are rated versus the simple “good” vs. “toxic” diagnosis that we currently have.

Here is the article:

One Cheer For Barney Frank – WSJ.com, December 23, 2009

Don’t Put All Your Ratings in One Basket

Regulatory over-reliance on ratings isn’t just a U.S. problem. As we have seen here in the U.S.,  using ratings as the ultimate measure of value is dangerous.

Ratings are too blunt a tool to measure economic value. It makes the ratings agencies the default arbiter of capital levels. The stakes are too high to use a single statistic measure.

ECB Must End Moody’s Veto on Greek Debt, Goldman Says – Bloomberg, December 18, 2009

Finally, Some Comprehension

Hooray! The market is beginning to understand what the NRSROs have been doing.

The rating doesn’t speak to the magnitude of loss. The National Association of Insurance Commissioners (NAIC) are being proactive and not allowing downgraded bonds to suck all of the capital out of the insurance industry by year end.

We hope that the ratings agencies’ explanation, and clarification as to what the ratings do measure will become common knowledge.

There are bad bonds. But not all downgraded bonds are “toxic.”

S&P Gauges Bond Loss Potential on Morgages – WSJ.com, October 9, 2009

The Devil Is In the Detail

Collateralized debt obligations have become incredibly complex. So much so that the issuers, the actually assembler of these instruments, were sometimes unclear what it was that they had created.

Complexity should cause one to become wary. Particularly unnecessary complexity. And if you have invested in something you don’t understand, you have only yourself to blame.  It is one thing to sit through a presentation, hear the detail explained in glowing terms, but when you’re back at your desk you need to decide. If you’re taking a leap of faith based on what you heard in a conference room, you’re likely making an unsound decision. Plenty of investors didn’t buy these “Goldbergian” securities.

Trying to regulate complexity out of investment is unwise. Complexity can help to mitigate risk and improve return. Instead, investors need to take a deep dive into the detail. It is the issuer’s responsibility to ensure it can withstand scrutiny. If not, the decision to leave it alone should be obvious.

Next Page »