Rating agencies must get their houses in order while waiting to see how regulators and investors will ultimately rate them, writes FIONA REDDAN

AS REGULATORS on both sides of the Atlantic prepare to introduce sweeping changes to the way credit rating agencies operate, their future looks uncertain.

Where once the oligopolistic trio of Moody’s, Standard Poor’s (SP) and Fitch saw their businesses soar in line with the explosion in structured credit products, now their stock prices are plummeting and their rating actions are being discredited. They face a fight for their future, as regulators take a hardline approach and investors increasingly ignore them in favour of their own analysis.

Traditionally, investors relied on rating agencies to determine the likelihood of default of a particular security, with ratings ranging from the most secure, AAA, down to “junk bond” status being attributed to sovereign states and a variety of credit instruments.

But investors no longer pay for this service, issuers do – and that is where the current problems have arisen.

Under the issuer-pays model, the rating agencies pitch for business from issuers looking to have their securities rated – an exercise which can cost several hundred thousand euro. As a result, they are very much dependent on issuers as a source of income.

While credit ratings aren’t obligatory – after all, plenty of unrated debt instruments are available for sale – they are seen as essential if an issuer wants mass marketability for their issues, with some investors only purchasing rated product. As one trader pointed out, no one would have bought collateralised debt obligations (CDOs) unless they were rated.

Given the vested interest issuers have in achieving favourable ratings to boost marketability (the higher the rating, the bigger the demand for the security and the cheaper the funding), who is it that usually wins their business – the rating agency which promises a decent rating, or the one that acts more in line with investor interests?

While such a scenario is obviously not always the case, this shopping around for ratings does lead to some very serious conflicts of interest. It became particularly problematic during the global rise of structured credit products such as CDOs and collateralised loan obligations (CLOs) earlier in this decade.

As the volume of securitised products soared, rating agencies were accused of getting into bed with issuers, helping them to construct such products and inflating the creditworthiness of certain securities, particularly those related to US sub-prime mortgages – all in an effort to win market share to appease shareholders.

Ultimately, investors were left high and dry, stuck with junk bond products which had been rated AAA, triggering the first phase of the global financial crisis.

Targeted for blame early in the economic crisis, the focus of attention had moved elsewhere as governments focused on stimulus packages. However, a series of contentious downgrades of sovereign debt in Europe, just as EU governments were putting together support programmes for the euro, brought the role of the rating agencies to the fore once more.

It isn’t just the rating agencies though that have been accused of working the system to their advantage. Issuers, such as the investment banks which constructed the structured credit deals, took advantage of the increasing transparency in the system caused by the decision of ratings agencies to disclose their rating methodologies. Applying reverse financial engineering, issuers were able to structure their securities in line with the published methodologies. This allowed banks to get better ratings than they might otherwise have been able to do – which meant, in turn, that they were able to achieve better prices for their transactions.

Credit rating agencies staff found themselves in demand from banks looking to hire them for their experience of how the system works, leading some to question whether some sort of post-employment limitations should be applied to credit rating agency staff, effectively preventing them from taking up positions with issuing institutions such as banks.

Now the rating agencies are preparing for judgment day, as regulators in the US and Europe decide on appropriate measures to rehabilitate and rebuild the industry.

“I think they have a serious credibility issue at the moment. They’re being attacked from all sides,” says Dermot O’Leary, chief economist with Goodbody Stockbrokers, adding that “we will need to see wholesale change” before the agencies can address their credibility deficit.

Already, there have been significant changes. From December this year, rating agencies in Europe will come under the regulatory supervision of the nascent European Securities and Markets Authority (ESMA), while rules aimed at increasing disclosure levels have been introduced on both sides of the Atlantic.

Earlier this month, the Securities and Exchange Commission (SEC) introduced a new rule requiring raters to disclose huge amounts of information about securitised transactions, while, in Europe, the commission made a similar move, requiring raters to make accessible the information on which they base their decisions to all rating firms.

It is the rating agencies’ role in the Greek crisis of the past few months which is leading regulators to significantly up the ante. What appears to have angered European policy-makers the most was SP’s decision to downgrade Greece to junk status in April, a time when the country was working on getting itself out of its financial difficulties and was announcing significant budget cuts. Moreover, Moody’s decision to downgrade the country’s sovereign credit to junk status earlier this week led to more havoc on bond markets.

European Central Bank executive board member Jürgen Stark last week decried the part rating agencies have played in increasing the overall jitteriness of European markets, arguing that their decisions come too late. “They [ratings agencies] follow the market, they act in a pro-cyclical way, and this is not helpful,” he said.

“They’re following rather than leading,” agrees O’Leary.

Stark also pointed to the growing irrelevance of rating actions by the agencies, suggesting that the ECB did not take ratings as gospel. He is not the only one, with investors increasingly seeing credit raters as having lost their mandate. Renowned investor Warren Buffet – himself a significant shareholder in Moody’s – has declared that he rarely follows credit ratings, and would encourage investors to do their own thorough due diligence instead before making an investment.

As O’Leary points out, the markets are the real arbiters of performance, and they have consistently shown themselves to be ahead of the actions taken by the rating agencies. “In Ireland’s case, the market was pricing a rating downgrade in for quite some time. When it did happen it had no real impact,” he says.

But if investors no longer rely on credit ratings, do the agencies have a real business case?

SP and Moody’s have already seen billions wiped off their respective stock market valuations as regulators get set to introduce a swingeing round of proposals.

Central to the US proposals is the creation of a government committee, consisting of investors and other interested parties, which would be responsible for assigning raters to issuers who need securities rated. This would mean that issuers could no longer shop around among credit rating agencies for a security’s initial rating.

According to Senator Al Franken, who has sponsored the bill: “Under this measure, issuers will no longer be able to choose a rating agency and directly influence what kind of ratings they can get. We’re cleaning up Wall Street’s dishonest system and replacing it with one that rewards accuracy instead of fraud.”

Moreover, the US proposals see rating agencies facing increased liability, which would leave them open to lawsuits from issuers and investors, who will argue that they were missold securities during the boom.

In Europe, having brought the agencies into the regulatory fold, the commission still has additional items on its agenda, such as creating its own independent rating agency and looking to create more diversity in the marketplace.

Given that just three agencies dominate the global market, the lack of competition has been a cause of concern – especially as all three are US-based and seen as US-centric. While there are some other providers, such as Toronto-based agency DBRS, along with emerging players like K2 Global Partners, they have struggled to make a significant impact.

But is more competition really the solution? In Europe, European Commission president José Manuel Barroso thinks so.

“The lack of competition is of particular concern,” he said at the launch of the commission’s proposals on regulating credit rating agencies earlier this month, querying whether or not it was normal to have only three parties active in such a sensitive sector, where there is a great possibility of conflicts of interest.

There are some dissenters to encouraging more competition, however. For O’Leary, “it’s more an issue of regulation than competition”, while Buffet argues that the existing level of competition has actually been partly to blame for the latest crisis, with rating agencies competing for market share based either on price or a lowering of ratings standards. He has suggested a monopoly would be the best solution.

His thesis is borne out in research produced by Harvard Business School, which has shown that Fitch’s emergence as a leading player in the market, alongside Moody’s and SP, actually led to an increase in triple-A rated securities, indicating that competition in credit ratings forces the agencies to favour issuers who are paying for their services, rather than investors.

As such, it has been suggested that a supranational agency such as the International Monetary Fund (IMF) could take over responsibility for ratings, or an independent European rating agency free from conflicts of interest could be created.

Would such institutions really be independent? Given how the ECB recently changed its rules on investment grade bonds to facilitate Greece, O’Leary thinks not. “They could change the rules to suit themselves in certain circumstances,” he points out.

So for now, rating agencies must try to get their own houses in order while waiting to see how both regulators and investors will ultimately rate them.