Measuring the Markets

By Patrick Corby

In 2007 the falling value of highly rated Mortgage Backed Securities (MBS) lead to a mass of exposed speculation in western markets. Since this time credit rating agencies (CRA) have seen their role and performance come under increased scrutiny.

Credit rating for firms have been used for over 100 years to provide the service of analysing the associated risk in sovereign and corporate debt instruments. Until now this has largely been done without regulation under the principle of free speech, may this be about to change.

Most of the panic that has centered around credit rating agencies is largely due to the misconception that their ratings are investment recommendations rather than market opinions. The ratings that credit rating agencies such as Fitch, Moody’s and Standard & Poor present are market opinion on the relative credit risk associated with particular firms or nations. Their main advantage is that they have the ability to assess thousands of firms with a consistent methodology that would be too much of an undertaking for any one individual.

A credit rating is not a guarantee, it does not provide an exact scope or definitive measure on the quality or default risk of a security. Ratings are a ‘relative’ measure of one firm defaulting over another. A bond rated ‘BBB’ is more likely, the agency’s opinion, to default over an ‘AAA’ rating, but non are safe from default all together.

So what is a rating

Standard and Poor, one the three major CRAs, publish more than a million security credit ratings on over 200,000 organisations across the world. Investors use these respected opinions to gauge their analysis on the consistent methodology used in the analyse by agencies.

Market value, volatility and investment fitness do not depend on the rating on the instrument but instead on the fundamental position of the issuer which is analysed and rated through a preconceived system of rank.

When investors assess the fitness of a security the credit rating is just one of many tools used to gain an in-depth analysis. Ratings give a third perspective – an independent analysis – that is consistently comparable.

S&P states that ‘ratings are meant to be relatively stable and do not fluctuate on the basis of sentiment’ they are ‘views of the fundamental creditworthiness of a borrower or security’.

Therefore speculative sentiment that can cause price volatility in an instrument based on speculative volatility such as a credit default swap (CDS) is not reflected in the credit rating of an instrument. The conception of ratings as ‘get in’ or ‘get out’ is sorely misguided and causes much distress in the market when speculation takes hold.

Credit rating will have some speculative affect to influence price. This is the case with many factors in the market value of a security and does not excuse the sole reliance upon ratings when analysis is performed. This seemed to be the case in much of the securities that were involved in the financial crisis.

Credit Ratings are valuable tools and have been historically accurate in the past. Between 1981 – 2011 the S&P 5 year corporate securities rated ‘BBB’ and above had a 1.17% default rate compared with those rated below ‘BBB’ which had a 16.82 default rate. Based on Europe the same trend can be witnesses: with those rated ‘BBB’ and above having a 0.5% default to 11.15% rated below the ‘BBB’ rating.

The IMF has noted that since 1975 those sovereign issues that S&P rates have a foreign currency default rate of 1% in 15 years from the issue. While those rated ‘non-investment’ grade have a 30% default rate and held that rate at least one year before defaulting.

Since the Financial Crisis

Since 2007 CRA have had to hold their own on a lot of allegations in a speculative atmosphere, individuals and nation states have pointed the finger of blame taking no responsibility themselves.

It is true that credit ratings do and will influence price movements short term. It is also true that CRA are not free from manipulation. But that credit ratings lead to speculation is absolutely false. What leads speculation is credit expansion and a loose constraint on bank lending and capital requirements (something that is being fixed presently). Credit rating agencies can only be blamed as far as any other influence that leads the expansionary supply of money necessarily somewhere.

Since the crisis was uncovered states have wanted a tighter control on symptoms of speculation including CRAs. Now in place is a regulatory body to supervise the opinions of CRA in the hope that states can rightly time ratings to beat market speculation.

The ESMA

On October 31^st 2011 the European Union registered all the major rating firms including Fitch, Moody’s and Standard and Poor’s in the regulatory body the European Securities and Market Authority (ESMA). Before this rating agencies were not subject to any kind of regulation.

The ESMA, the body that supervises the credit rating agencies, has powers to inspect and sanction non-compliance. The rules and regulations that it is responsible for supervising and enforcing are still in negotiation around the draft proposed by Michel Barnier and once agreed are set to come into force early 2013.

“[Credit rating agencies] will follow stricter rules which will make them more accountable for mistakes in case of negligence or intent.”

Calendars

CRA’s will now have to provide a calendar of when they will rate sovereign and corporate issues. Having to comply with providing the ratings one hour before markets open or after they close. Being published in parallel on the European platform to increase visibility.

This comes at a time when the Italian and French governments has asked for prosecution of credit rating agencies that released damning downgrades at unopportunistic times causing sell-offs of bonds and strong market volatility.

S&P has responded “We will continue to perform our role without fear or favour of any investor, debt issuer or other external party and to defend our actions, our reputation and that of our people.”

Transparency

Transparency has also been driven by the ESMA launching a probe to inquire banks evaluation process. Countries and banks that issue financial instruments will see the fees they pay publicly published and having to be rated by at least two CRA’s.

Markets will see more transparency in CRA’s methodology; ratings might even be subject to approval by the ESMA itself. With the aim of producing a ‘harmonised rating scale’.

Credit rating agencies and investors have attacked this particular reform as forcing the agencies to “replace [methodologies] with lower quality ratings driven by a uniform ‘semi-nationalised’ approach”. And its true, some of the proposals do have an air of nationalisation surrounding them, a interventionist approach to those who provide a comprehensive analysis of debt.

Although now stricken from the proposed regulations the draft argued for the possibility of suspension of sovereign ratings in ‘exceptional situations’. Allowing the ESMA to restrict ratings of bailed-out nations and adverse ratings that might be produced at a “inappropriate time”.

“In order to prevent credit rating agencies issuing sovereign ratings which do not accurately reflect the situation of the country concerned and would cause negative spillover effects to other countries, Esma should be granted the power to temporarily restrict the issuance of credit ratings in exceptional, precisely defined situations,” the draft by argues.

In this case the point that ratings are driving speculation is painfully obvious.

Rotation

The most contentious of the reforms would be the rotation principle. That states all companies would have to ‘rotate’ their agency every three years for a hiatus of four years before returning.

“The credit ratings agency engaged should not be in place for more than three years or for more than a year if it rates more than ten consecutive rated debt instruments of the issuer,” according to the draft.

Along side supervisory and regulatory control CRA are now seeing an increase in court cases that blame them for price movements, making it seem that now firms are scared of the once triumphed ‘shake out’.

Law Suits

Credit rating agencies will also be targeted for law suits if their rating causes mass volatility and losses for individuals and firms.

Back in 2009 when an Abu Dhabi commercial bank took Moody’s and S&P to court over what they felt was a misrepresented rating Laura Veldkamp, associate professor of economics at the New York University Stern School of Business, is on the record stating that “One of the big hurdles to suing ratings agencies was this idea that ratings were first amendment speech and that is exactly what [the 2009] ruling calls into question.” The trail over this case will continue next May.

More recently though an Australian court has ruled against S&P that has proved a land mark case against CRA. The case involved a AAA rating on a derivative instrument that collapsed 90% 2 years after its launch by ANB Amro.

The federal court ruled that ANB and S&P ‘mislead’ the public into buying into the ‘constant proportion debt obligation (CPDO), a instrument designed to pay the same rate as a junk bond yet keep a very high credit rate, in 2006. By either ‘misrepresentation’ or outright ‘falsification’ of information. –

The 1,500 page ruling marks the first time that a CRA has seen full trial litigation over financial products and its provided services.

“No longer will rating agencies be able to hide and absolve themselves from liability.” said Amanda Banton, the lawyer representing the party who bought into the CPDOs.