Ratings giants in the line of fire

YOU wouldn't credit it. Or perhaps you would. For a fee. In most areas of financial life, you would be shocked if you got "independent" advice on a product only to find out later that the adviser had been paid by the company producing it.

Obviously an open-and-shut case of conflict of interest? Not in the abstruse, obscure world of credit agency ratings.

The mud continues to fly in the wake of the subprime mortgage-backed securities lending fiasco.

Critics say the credit rating agencies (CRAs) were asleep at the wheel, giving "triple-A" ratings to complex, largely mortgage-related bonds that turned out to be junk.

Sometimes the reverse alchemy of gold-into-lead happened only weeks after the bonds, often referred to as collateralised debt obligations, were AAA-rated.

This means very safe, with buyers having a good chance of getting their money back with interest.

In the dock are the three agencies that dominate the sector: Standard & Poor's, Moody's Investors Service and Fitch Ratings.

The three play a key role in the fortunes of companies because markets rely on their opinion as to the financial health of the businesses and their products.

But critics say the CRAs deserve the flak they have received because they were largely still saying subprime bonds were safe almost right up until the trains hit the buffers in 2007.

A joint paper by David Wood, executive director of technical policy at the Institute of Chartered Accountants of Scotland, and Professor Angus Duff, of the University of Paisley, says the public and political outcry against the CRAs is deserved.

"That's because ratings given to structured finance products can, with hindsight, be said to have been generous. Indeed, recent research indicates that collateralised debt obligations rated by Moody's were ten times more likely to default than equivalently rated corporate bonds," the pair say.

Worse, controversy and amazement have grown as the veil has been removed from a legal, but almost masonic, world to find ratings agencies are paid by the bond-issuers not the bond-buyers. In fact, there is evidence that sometimes the cart was put before the horse with ratings on so-called structured finance products.

CRAs might first advise the issuer how the construction of a bond would affect its overall credit rating before it was actually issued. If the agency later issued a rating it earned a fee each time.

Amid the "cosy" relationships, there were stories that agency analysts were socialising with clients. Golf, karaoke nights...

But the credit agencies say there is nothing hidden about issuers paying for the ratings, and the industry is so big and hard-wired into the financial world now that they could not just survive on subscriptions. It would mean extra costs for the borrowers.

This is all quite apart from the criticism that S&P, Moody's and Fitch essentially have a cosy oligopoly, with little recognised competition.

And the fact that the agencies are unregulated by the Financial Services Authority in Britain.

An FSA spokesman said: "The ratings agencies are not currently regulated by us. But we know the Central European Securities Regulator, with whom we work, is looking at them."

The agencies are regulated in the US by the Securities and Exchange Commission. But even there things are far from clearcut as far as, for example, potentially taking errant agencies to court is concerned.

The CRAs have historically claimed protection under the US constitution's First Amendment, protection of the freedom of the press – treating ratings as mere journalistic opinion.

But, as ICAS says, given that CRAs are given privileged access to a company's senior management to construct their ratings and gain a picture of a product, "to insist that this equates to journalistic opinion is stretching credulity".

Other leading financial academics have put their finger on a key failing in how credit rating agencies gave a false picture of the health of the dodgy bonds. Triple-A ratings were often based only on largely positive historical repayment default patterns

If the backdrop worsened dramatically for packaged-up mortgage bonds, for instance the sudden and sustained rise in interest rates by the US Federal Reserve, then the optimistic ratings models were useless.

Roman Frydman and Michael Goldberg, authors of Imperfect Knowledge Economics, say: "Requiring the agencies to rate securities under one or more pessimistic scenarios as well as the optimistic one would make it harder for the agencies to deliver rosy ratings in return for business from the investment banks."

Like much wisdom with hindsight, that insight seems pretty much a statement of the obvious given the dubious part the ratings agencies played in the financial meltdown that engulfed us all.

BACKGROUND

MOODY'S, one of the world's three biggest credit rating agencies, yesterday defended its business model.

"Any business model, investor-pays, issuer-pays or government-pays, has the potential for conflicts of interest.

"The issue is how we manage the potential conflict, not whether there is a potential conflict."

A spokesman said Moody's employed safeguards at the institutional, rating committee, and individual analyst levels, "to mitigate potential conflicts of interest".

These included that ratings were assigned by a committee, not an individual analyst.

On competition, the Moody's spokesman said the company had long supported "the objectives of more competition, greater transparency and accountability among credit rating agencies".

Neither Standard & Poor's nor Fitch, the other big players, were available for comment yesterday.