WHEN MANY subprime borrowers in the US mortgage market defaulted on their loans last year, the result was turmoil in financial markets and a contraction in global credit that is continuing. The subprime market caters for borrowers with poor credit records. The problem that arose in the US stemmed from reckless borrowing by house buyers and imprudent lending by banks and finance houses. As interest rates rose and property prices fell, many homeowners were left holding negative equity and went on to default on their debt.
The banks, however, had bundled and repackaged these subprime loans as mortgage securities and bonds and sold them on to other investors – including European banks – as low risk investments. By securitising these loans, the banks transferred the default risk to other investors who, for two reasons, failed to see the underlying risk in some of these financial instruments. One was the financial complexity of the mortgage securitisation process where many different loans were bundled, thereby obscuring the investment risk. But the other was a failure by credit rating agencies to assess correctly the investor risk involved. For agencies, such as Standard Poors and Moody’s, there is a potential conflict of interest in their method of operation. They are paid by the companies whose creditworthiness they assess and whose financial products they rate. The credit rating agencies are the customers of the debt issuers rather than of the investors who buy that debt. And that hardly inspires investor confidence.
EU internal markets commissioner Charlie McCreevy yesterday signalled a much tougher supervisory stance when he announced that the credit-rating agencies would face mandatory European Union regulation. He accepts that this is necessary given the failure of self-regulation and his evident dissatisfaction with the revised code of conduct recently drawn up by the International Organisation of Securities Commissions (IOSCO), a group of market regulators. He has dismissed IOSCO’s proposal as being well short of what is required to restore investor and public confidence. Clearly, one of Mr McCreevy’s intentions in framing his reforms is to attract new rating agencies into the market. His hope is that new entrants would operate to a different business model, provide much needed competition and restore public and investor confidence in the credit rating system. Greater regulation of rating agencies has been long overdue and Mr McCreevy is taking a bold step in the right direction.