Fitch Worries About Unrated Debt

The number of high profile companies that have been selling unrated bonds or structured securities has been growing since the credit collapse in 2008. Formerly unrated investments were the purview of high-risk junk bond issuers.

The Wall Street Journal quoted Peter Sack of Credit Suisse’s mortgage-backed securities structuring group as claiming, “Two years ago, deals like this would have been inconceivable…Now they are a viable option.”

Whereas getting a risk appraisal from the leading ratings agencies was once automatic, in the wake of the credit crisis many of their ratings were shown to be unreliable. This has rattled investor confidence to the point that in some instances issuers have concluded that their evaluations are superfluous or worse, worthless.

As long ago as August 2009 Bob Kunze-Concewitz, chief executive of Italy’s Gruppo Campari, was quoted as saying, “Our reputation is good….I don’t think a rating would have mattered that much.”

Fitch Ratings – London in a recent report warns investors about the risk of unrated issues.  They also indicate that approximately half of the non-rated issuers in 2009 could have been investment-grade.

SEC Steps In To Untangle Conflicting Regulation

The Securities and Exchange Commission (SEC) was needed recently to unravel an impossible situation that resulted from the newly passed financial reform act.

The new law creates legal liability for the evaluations that the ratings agencies assign to new bond issues. As a result, the ratings agencies refused to allow clients to use their ratings in documents needed to register new bond products. However the issuers are required by the SEC to include these ratings in their registration documents.

Bond issuers found themselves in an unworkable position and, in this case, the market selling new bundles of auto and consumer loans came to a full stop.

To circumvent the problem, the SEC announced that for the next six months ratings would not be required to register new bond products.

In a prepared statement Meredith Cross, director of the SEC’s corporate finance division said, “This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement while still conducting registered ABS (asset-backed securities) offerings.”

The confusion caused concern among the investment community. The Washington Post quotes Jeffery Elswick of Frost Investment Advisors as saying, “It’s still kind of murky…I’ve been involved in the asset-backed markets for 18 years, and I don’t understand [the legislation] at this point. If I don’t understand it, a lot of people don’t.”

Canada Proposes New Rules for Ratings Agencies

In an effort to reduce the risk of credit rating agencies’ conflicts of interests, the Canadian Securities Administrators (CSA) are proposing a requirement that credit rating agencies apply to become “designated rating organizations,” or DROs. These DROs would then be required to establish policies and procedures to manage conflicts of interest.

In a statement posted on CSA’s web site, Jean St-Gelais, chairman of the CSA, said that because investors rely on credit ratings when making investments and ratings continue to be referred to within securities legislation, it is necessary to develop a formal regulatory oversight of credit rating organizations. St-Gelais also explained that “This CSA initiative is consistent with international developments in addressing the oversight of credit rating agencies, which can have a significant impact upon financial markets.”

Although the new regulations will provide Canadian regulators with the power to demand changes in the way agencies operate, the proposal stops short of overseeing credit rating content or methodology.

Standard & Poor’s May Lower Moody’s Rating

Standard & Poor’s has announced a 50% chance that it may downgrade the short-term credit rating of Moody’s Corporation.

Listing Moody’s A1 short-term rating on CreditWatch with negative implications, S&P credit analyst Emile Courtney said in a statement, “An increased level of business risk is likely following the announcement that the Financial Reform Conference Committee has reconciled bills from the U.S. Senate and House.”

The analyst added, “The agreed upon legislation could result in a change in the applicable pleading standards for certain litigation brought against rating agencies,” making them easier to sue. “Nevertheless, we believe that Moody’s may face higher operating costs, lower margins, and increases in litigation-related event risk, which would likely increase its business risk,” she said.

Credit Unions Join Rating Agencies in Criticism of Financial Reform Bill

The U.S. House of Representatives Democrats approved a plan to place a new financial consumer watchdog within the Federal Reserve.

The independent unit would have substantial budget, staffing and rule-making power, and would consolidate consumer-related duties now dispersed across several agencies, including overseeing mortgages, credit cards and other consumer financial products.

House Democrats also said they will support putting new limits on debit card transaction charges, known as interchange fees, with some changes to a proposal that was originally offered by Senator Richard Durbin (D-IL.)

Mr. Durbin said the changes would exempt prepaid and debit cards used in distribution of government benefits. He said the agreement would allow the Fed in some cases to adjust fee rates on cards for fraud prevention costs.

The National Association of Federal Credit Unions (NAFCU) said it was “greatly disappointed” by the agreement on Durbin’s proposal, predicting it would raise consumer costs and place credit unions at a disadvantage versus large card issuers.

The NAFCU joins the three major credit ratings agencies in criticizing the final financial regulatory reform bill.

Bank Regulators Want Less Reliance on Rating Agencies

Bank regulators are currently drafting rules that would require banks to prove they had done adequate research before they could receive the regulatory capital benefits of holding highly rated bonds from securitizations. Regardless of how its holdings were rated, a regulated institution that depended exclusively on ratings for evaluating an investment’s safety would have to hold loss reserves against the full value of its position.

“If you can’t use a rating because you don’t want to get all the information, then presumably you won’t buy the instrument,” said a source close to the Federal Deposit Insurance Corporation, according to American Banker.

Certain legislators support the even more drastic approach of stripping “nationally recognized statistical rating organizations” such as Moody’s Corporation, Fitch Inc. and Standard & Poor’s of any official recognition in regulatory capital requirements. This is a positive sign. D.C. can’t say ratings are worthless and the process is corrupt, and then base capital ratings on NRSRO ratings. Let’s move away from the exclusive use of ratings.

No Drastic Changes for Standard & Poor’s

In comments to Reuters, Standard & Poor’s President Deven Sharma said that a credit rating agency board, as proposed by the bank reform bill, would not disrupt his firm’s business model.

“We will have to go to investors and convince them that, ‘look, you still want a rating from us.’ We’ll have to work harder to get those mandates from the investors and from the issuers directly.”

Mr. Sharma also commented that his company had taken measures to add more checks and balances since the subprime mortgage crisis. “For example, it is going to be much more difficult for a mortgage-backed security to get a triple-A going forward.”

After pointing out various changes in his organization around analytics and various other governances, he offered, “Not everything went right in the past, and we recognize that. And there were analytical misses, and we know we have to learn from that and fix things. But at the same time, we are going to stay true to our purpose, which is offering a risk benchmark and calling it as we see it and taking the heat as it comes along.”

Large Investors Rely on Their Own Systems

The Economic Times reported on how large investors are turning to their own rating systems, so as to not have to rely solely on credit rating agencies. The subjects interviewed said that they were able to seize investment opportunities ahead of their competitors who still depended on ratings set by the agencies.

Bill Gross, managing director of PIMCO, the world’s biggest bond investor, said that rating agencies “no longer serve a valid purpose for investment companies” if they do not become more nimble than they are currently.

Bob Pozen, chairman of MFS Investment Management, said that having an internal system allowed them to change direction more quickly. Commenting on other investors who rely on the slower-moving rating agencies, he said, “they can’t change a rating until the objective evidence becomes compelling. We look at objective evidence but also trends and market judgments.”

In spite of these shortcomings, Mr. Pozen also asserted that the rating agencies still served an important role as a longer-term reference for investors. MFS and PIMCO prove my point. Let’s delete the use of ratings from the federal register. You can invest without an NRSRO. Why is this so hard to see?

Former Ratings Officials Testify Before FCIC

Eric Kolchinsky, Moody’s former managing director in charge of rating subprime mortgage securities, testified before the Financial Crisis Inquiry Commission. He told of how superiors pressured analysts to increase market share. He said that bankers seeking reviews for their mortgage securities took advantage of this by giving rating agencies no time to conduct proper reviews of the securities.

“That was the problem,” said Mr. Kolchinsky. “I said I needed three or four weeks to research the deal, but because bankers knew we could not walk away from a deal, they sent the documents three or four days before closing or even after closing.”

FCIC Chairman Phil Angelides, former state treasurer of California, remarked that, “The very system didn’t allow you to say no to a whole market slice.” Moody’s could have said no. They chose to rate. This is corporate responsibility, not ratings shortfalls.

Greenspan: Rating Agencies Major Factor in Crisis

At a congressionally appointed panel investigating the causes of the financial crisis, Former Federal Reserve Chairman Alan Greenspan criticized credit rating agencies for doling out high marks to securitized subprime mortgages, inculpating them for their role in creating the current financial crisis.

“All I will say is what I can say for myself, [which] is that the ratings that were developed by the credit rating agencies were a major factor in the cause of the problems,” he told questioners.

Many fingers have been pointed at credit rating agencies for the top grades they assigned to securities based on subprime mortgages that then ran into repayment problems or defaulted.

However, this is a mistake. There were bad bonds and bad structures. But the rating system downgrades were driven by what the ratings measured: the first dollar cost. By the way, don’t investors bear some responsibility for their own investment decisions?