If on 1 September 2008 you decided to invest money in safe A rated and above bonds, and checked for a list of companies, you would have come across some fairly familiar names?Lehman brothers, Merrill Lynch, and AIG. Being a cautious soul, you conducted some extra due diligence and checked whether these companies were rated high by both the venerable Moody?s and S&P, and you would have been reassured both the raters thought of them similarly. In fact, if you went further, to check whether these companies were actually safer to invest into than Indian Government securities, again, you would have been comforted?all these companies carried a risk rating higher than India?s BBB-. Unfortunately your due diligence would not have saved you your money. By the end of the month, your Lehman bonds would be worth nothing.
Almost farcically, S&P?s, in detailing its new recovery assumptions for structured finance CDOs, recently revealed that for any deals rated A or lower, recoveries were likely to be zero, while recoveries for AA-rated slices of such deals would be at best 5%. The most senior, or ?super-senior?, AAA-rated tranches were likely to recover 60%, while junior AAA-rated tranches could expect to recover only 35%. However in 2007 the agencies felt aggrieved at the criticism of their ratings when things had started to look shaky. S&P said it had downgraded just 1% of sub prime residential mortgage-backed securities, and that none of those downgrades affected the triple-A bonds. They went on to add that defaults had hit only 3% of the mortgage tranches they had rated. Of more complex products, collateralised-debt obligations (CDOs) downgrades had affected just 1% of securities by value.
What happened? Elementary, my dear Watson, would be Arthur Conan Doyle?s comments. In 2006, nearly $850 million?more than 40% of Moody?s total revenue?was derived from the world of structured finance. In contrast, this sector accounted for just $50 million of its revenue in 1995. During the period between 2002 and 2007, Moody?s net income rose from $289m to $754m.
These rating agencies earned huge fees in the past ten years offering opinions on the creditworthiness of all kinds of structured vehicles related to mortgage-related securities created by highly leveraged banks. As the market for credit default obligations blossomed so did the profits of the rating agencies. Could the fat fees they were earning have lead to a drop in standards? The reputation of the rating agencies today is clearly in taters. Whatever the agencies may say, few would trust an American bank bond, whatever its rating, over an Indian Government security.
It is instructive to recount how this system came into being. It arose out of the need of the Securities and Exchange Commission (SEC) in the 1970s to ensure that the brokers it regulated had enough capital. Instead of trying to research every single bond itself, it was much easier for the commission to accept the opinions of a few agencies. The SEC granted respectability to a few agencies known as Nationally Recognised Statistical Rating Organisations, or NRSROs. Bank supervisors built on the SEC and made ratings a part of the financial system. This regulatory need created a fairly lucrative and protected oligopoly for these agencies.
The important question today is, can this go on? There is a clear conflict of interest for the rating agencies as they are paid by the issuers whose securities they rate. The current crisis shows the extent to which they have been wrong and regulation based on a model of ratings cannot be justified. Alternatives are not easy to work through as no one else wants to pay for the ratings. Oversight of the financial system is getting even more complex and all the third parties that regulators depended upon?the raters, the auditors?are not covering themselves in glory. I think it?s time for the regulators to do more themselves.
?The author is managing director, BCG India. These are his personal views