[Reader-list] the rating kinds take a battering

[lalitha kamath]

How the financial crisis has affected rural New South Wales shire councils and the role of the credit rating agencies. This compels a harder look at the doings of the ratings kings in Indian cities...


The rating kings take a battering
 Ruth Williams 
September 6, 2008
http://business.theage.com.au/business/the-rating-kings-take-a-battering-20080905-4asw.html?page=fullpage#contentSwap2
Business Day The Age Australia

THEY are staid, respected, low-profile
institutions. At least they were until very recently. Their services are both
expensive and indispensable. They have a profound influence on investment
markets around the world, and therefore, a profound influence on the wealth or
otherwise of investors big and small.
And many people believe they were a key contributor to what we now know as
the subprime crisis.
They are credit rating agencies. Globally, there are three of note: Standard
& Poor's, Moody's Investors Service, and Fitch Ratings. And over the past
eight weeks, their reputation has taken a battering. They have been accused of
conflicts of interest and even incompetence. They are being sued in the US and slapped
with extra layers of regulation in the European Union. They are being blamed,
in part, for events that have bankrupted companies, pushed mortgage holders out
of their homes, and that have rocked financial markets worldwide.
And here in Australia they are implicated in losses suffered by some of the smallest and least
financially sophisticated institutional investors in the country, including
rural shire councils.
It is all a giant mess that has "significantly undermined" the
credibility of the rating agencies, according to Melbourne University corporate law expert Ian Ramsay. And, some believe, it may lead to
unprecedented legal action in Australia.
The Age has revealed the extent of losses councils have suffered
around Australia,
which invested millions in complex financial instruments known as
"collateralised debt obligations" (CDOs) that were sold to them by
Grange Securities, since bought by Lehman Brothers.
What is happening in rural NSW, and in other states, is a microcosm of
events taking place around the world. Understand what happened there and you
understand the root of the subprime crisis, and how the credit rating agencies
were the conduit for the whole thing — how they facilitated it; how they let it
happen.
It all begins with a set of guidelines. Councils in NSW, as with many
institutions, are restricted in how they can invest surplus money. Property is
OK. Deposits with banks, credit unions or building societies are OK. And,
crucially, any securities rated at least "A" by S&P, Fitch or
Moody's are rolled-gold, guideline-approved OK.
So when broker Grange Securities came courting in late 2006 with Federation,
a form of CDO, many rural councils saw no reason not to invest. It was,
according to Grange, "linked to the performance" of a portfolio of 40
bonds backed by "diversified US residential mortgage pools" — bonds
that were rated AA- or A by S&P.
What does this mean? Basic, "vanilla"
CDOs consist of a pool of debt securities, or bonds, that are split up into
securities. The bonds, and therefore ultimately the CDOs, can be backed by
income flowing from corporate loans, or small business loans, or mortgages.
They are then divided into different classes, or "tranches", based on
how well protected the yield is. If the loans default, it is the lowest,
least-protected tranche — the tranche with the highest yield — that is impacted
first. The damage then moves up the ladder of tranches.
Then things get more complicated. Somewhere along the way, someone created a
"synthetic" CDO, which was cheaper and easier to put together and
sell. In effect, synthetic CDOs involve transferring the risk of defaults from
one CDO to another party. They are complex derivative instruments that, fuelled
by plentiful mortgages in the booming US property market, became wildly
popular in the mid-noughties.
The problem was that much of it was based on puffery and misinformation — on
loans given to people who simply could not afford to buy a house.
"Subprime" once referred to a class of dodgy mortgages. Now it refers
to the financial pain that has flowed from the inability of those mortgage
holders to pay back their loans. It has spread well beyond "subprime"
mortgages to the complex financial instruments created on the back of those
mortgages. It has spread to rural Australia, where councils sank
money into products they did not understand.
So, where do the credit rating agencies come into it? Strictly speaking, the
role of these agencies is to judge the risk that an entity — such as a security
or bond — will default on its debt obligations. The agencies facilitate the
pricing of risk. "AAA" means the entity has a negligible chance of
defaulting. "BB" or "C" means it has a greater chance. They
are priced accordingly — the greater the risk, the greater the return.
This is an imperfect measurement of an entity's value, a fact the agencies
have not tried to hide. "The rating agencies have always sought to clarify
their role by stating their ratings only measure credit quality," the Bank
for International Settlements notes. "They state that a credit rating is
not intended to capture the risk of a decline in market value or liquidity of
the rated instrument, nor should it be considered an investment recommendation.
However, some investors do not seem to understand this point or simply ignore
it."
The rise of CDOs and other structured finance products
was a boon to the agencies. They started rating CDOs in the late 1990s and
synthetic CDOs in the early 2000s. These products were complex, even baffling,
to unsophisticated investors. The agencies made these incomprehensible products
sellable, and made themselves indispensable, by assigning them ratings.
A "credit default swap" is hard to understand. Triple-A? Everyone
understands what that means. Or at least they thought they did.
"The (instruments) were so lacking in transparency, you needed thousands
of pages of documentation to explain them," says Rob Ferguson, executive
chairman of litigation funders IMF. "They needed a simple thing to whack
on the front cover."
But the central question is whether the ratings assigned to the CDOs
properly reflected the risk involved; did they do what they were supposed to
do? Alan Laubsch, from risk management group RiskMetrics Labs Asia, says they
didn't for a relatively simple reason — the risk of defaults was calculated on
"recently observed" historical data, in which this year's drop in US
housing prices, and the corresponding drop in value of securities and
derivatives linked to the US housing market, was unimaginable.
"When CDOs became popular, every rating agency came up with some very
simplistic models to figure out what the chance of default on these was,"
Laubsch says. "The US housing market didn't drop since the Great Depression. So, looking at
historical data, it was inconceivable what happened. The problem with any
analysis which looks at things on a historical data basis, is that history
doesn't always repeat itself."
But the methodology wasn't the only problem — it was the entire business
model. An entity is only rated if it pays the credit rating agencies to rate
it, building into the model what the European Union has described as an
"inherent" conflict of interest.
As regulators in the US have uncovered, it was common for the agencies to modify their calculations
without explanation, the result of which may have been to grant clients better
ratings on certain securities. And analysts, the supposedly independent
calculators of the ratings, were involved in client discussions on fees and
market share.
A report on the three major rating agencies, handed down by the US
Securities and Exchange Commission in July, highlights all these issues and
more (while never naming which agency it is referring to). It highlights staff
shortages, painting a picture of institutions struggling to cope with the boom
in CDO-related work.
And it quotes from internal emails — "it could
be structured by cows and we would rate it" — that reveal the goings-on
inside these supposed bastions of corporate impartiality. In one email, written
in mid-December 2006, an agency analyst refers to the CDO market as "an
even bigger monster".
"Let's hope we are all wealthy and retired by the time this house of
cards falters. ;o)."
Sadly for the analyst in question, this was not to be.
When Grange was selling Federation in late 2006, around the time that analyst wrote that email, an "A" rating granted by the
respected S&P counted for a lot. So much, in fact, that even six months
later, when things had turned nasty in the US home market, Grange's new parent
Lehman Brothers could always point to the fact that the now-tarnished CDOs were
high-rated assets.
"Some commentaries have sought to lump all grades of CDOs … in a single
basket," Lehman told clients in a briefing note in July 2007, according to
documents lodged with the NSW Federal Court this week.
"This approach is the same as taking a triple-C rated corporate bond
and triple-A rated (government) bond and saying the risk and characteristics of
both bonds are the same … it is not valid to take the vast majority of CDOs
that (Lehman) has issued at AA- rating or better … and say they are subject to
similar risks to the very low-grade CDOs that invested primarily in subprime
mortgages."
A bit over a year later, that advice has wound up in a revised statement of
claim lodged this week by Wingecarribee Shire Council, which says it lost
millions on the CDOs in question. The council is suing Lehman Brothers, the
first council to make such a move. Others are considering similar action.
And of course, NSW shire councils weren't the only ones to glean confidence
from the bestowal of shiny ratings on rickety securities. "This is
something that has happened not just in Australia,
but throughout Asia and the world,"
Laubsch says.
A month ago, the European Union admitted its own legislation led to
"excessive reliance" by banks and financial institutions on credit
ratings. And in a high-profile Australian example, National Australia Bank said
it was likely to write off 90% of the value of its US mortgage-backed investments —
worth more than $1 billion — all of which had AAA ratings.
In unveiling the loss, NAB chief John Stewart was candid about the bank's
internal failings, saying the securities had passed internal risk checks. But
again and again, he pointed out the fact that the now near-worthless securities
had been given AAA ratings. "AAA means they have a one in 10,000 chance of
default," he told reporters. It was clear, he added, that the rating
agencies that had assigned the CDOs AAA status had "let the whole industry
down". "(They) didn't do a thorough job."
By the time NAB and Stewart 'fessed up, the house
of cards had faltered and then some. Worldwide, the agencies are under attack
for their role in the subprime mess.
The International Organisation of Securities Commissions, which describes
itself as "the leading international policy forum for securities
regulators", is scrutinising the rating agencies' performance against
their own codes of conduct, and will report its findings later this month. The
Financial Stability Forum, a group comprised of representatives from reserve
banks, treasury departments and regulators from 11 Organisation for Economic
Co-operation and Development countries, is also looking at the sector.
The EU, in effect, blames the agencies for subprime, acknowledging that it
was "generally accepted" that the agencies underestimated the credit
risk of structured credit products (like CDOs), and that their ratings
"failed to reflect early enough" the worsening market conditions. It
concluded that the rating agencies shared "a large responsibility for the
current market turmoil".
They aren't the only ones, of course. A slew of lawsuits have begun in the US against
investment banks like Citi and Merrill Lynch, against hedge fund operators,
home loan lenders, and others. The rating agencies are being sued by pension
funds and, in a move announced a few weeks ago, by the State of Connecticut. This
lawsuit, while not directly connected to the subprime fallout, has only added
to their recent reputational damage.
"We are holding the credit rating agencies accountable for a secret
Wall Street tax on Main Street — millions of dollars illegally exacted from Connecticut taxpayers," said
headline-friendly Connecticut Attorney-General Richard Blumenthal.
The agencies have pledged to fight the claims, which they say are without
merit.
As Wingecarribee prepares its case against Lehman, talk is building of
possible legal action in Australia against the credit rating agencies. Such a move is fraught with problems. IMF
is not looking at it and, Ferguson says, "they seem a very difficult group to challenge".
Why? After Enron collapsed, US investors tried suing the agencies for taking
too long to downgrade Enron corporate debt. In a landmark decision, the judge
ruled the agencies were expressing opinions, and so were protected under
freedom of speech laws.
Nonetheless, several bodies in the US are pressing on. And law company
Slater & Gordon, which says it has been approached by a "large
number" of investors burned by CDOs, is looking at whether there is a case
for an Australian lawsuit against the agencies.
Senior associate Ben Phi believes some of the
councils may have "valuable claims" against rating agencies,
"depending on their particular circumstances".
"In order to bring a claim against a credit rating agency, it would be
necessary to show that the credit report was misleading, and that the investor
reasonably relied on that report when deciding to invest," Phi says.
"We are aware that a number of local councils are required to invest in
products that carry a minimum credit rating, and they in particular may have a
valuable claim against a ratings agency."
NAB has not ruled out legal action. When asked about the prospect, it said
it was looking at a "range of options" on its battered CDO portfolio.
"(We) will continue to monitor the market and regulatory responses to
recent financial market conditions," the bank said.
In Australia,
that "regulatory response" includes a joint review of the agencies by
the Australian Securities and Investments Commission and Treasury. A crucial
aspect of the review will be the question of licensing — whether the financial
services licence exemption granted to rating agencies is, in the words of
Corporate Law Minister Nick Sherry, "still current or justified".
Last month, at an Investment and Financial Services Association conference
on the Gold Coast, ASIC commissioner Belinda Gibson acknowledged the
"questions raised" about the quality of the ratings processes,
identifying the agencies as one of ASIC's current priorities.
"There is a wider market issue about the extent to which investors rely
on the ratings agencies for their investment decisions, and whether the level
of diligence and discussion undertaken by the agencies warrants this
reliance," Ms Gibson said.
The Age believes that ASIC and Treasury will release a consultation
paper within weeks, and the final report is due by the end of the year.
The agencies have pledged to co-operate. "We want to provide as much
transparency as possible with regard to Moody's policies and practices,"
Moody's said in response to the ASIC/Treasury review. "Moody's will
co-operate fully with any review initiated by the Government."
The services of S&P, Moody's, and Fitch are believed to cost hundreds of
thousands of dollars — up to $1 million, in fact, to rate a complex,
high-profile issue.
S&P, which has the biggest presence in Australia, is owned by the
McGraw-Hill group of companies, which made $US1
billion ($A1.2 billion) in net income in 2007. S&P has about 130 employees in Australia,
or did at the end of last year. According to its latest financial statements,
lodged with ASIC, S&P Australia made $5.4 million in profit in the year to
December 2007 — a huge fall from the $13.1 million recorded in 2006. This drop
in profit and revenue it attributed to "the turmoil in global financial
markets", despite the fact that its parent company, the global S&P
group, managed to raise operating income by 13% over the same period, with
operating profit of $US1.3 billion.
Fitch Group, which is owned by French company Fimalac, recorded an 18% drop
in profit in the six months to March 31, to €79.2 million ($A137 million).
Fitch Australia,
according to financial statements lodged with ASIC, had just 23 staff at
September 30, 2006, and lost $2.23 million in the nine months to September 30,
2006 (the latest information available).
Moody's Investment Services is listed on the New York Stock Exchange, and
generated $US1.1 billion in operating income last year. It generates 60% of its
business in the US,
and classifies Asia Pacific as an "emerging market". It has about 60
"ratings professionals" in Australia.
Two years ago, few questioned the accuracy of the ratings processes the
agencies used. Professor Ramsay recalls attending an International Organisation
of Securities Commissions conference in 2005 where the issue of conflicts of
interest within credit rating agencies was raised. "It wasn't such a big
issue," Prof Ramsay says. "It seems like a generation ago now."
Now, everything is being questioned. Among the other faults uncovered in the
SEC report, one crucial failing was the area of "surveillance" — the
tracking of a security after it is granted that initial rating. Surveillance
was poorly documented and two of the agencies had no formal procedures in
place. Securities given high ratings were allowed to disintegrate before being
downgraded — the NSW Cole Commission noted that some Grange Securities CDOs
were still rated "A" by S&P, even when they were worth just 15%
of their original value.
Laubsch says the agencies were slow to respond to what was "clear
deterioration" in the subprime market. They did not start the bulk of
their subprime ratings downgrade until mid-July 2007, despite clear warning
signs (not least the implosion of the two Bear Stearns subprime hedge funds in
May).
The agencies have since moved to shore up their processes and rehabilitate
the thing on which their whole business model depends: their reputations.
"We haven't waited for the (ASIC/Treasury)
review to take steps that we believe will help improve our credit ratings
process," says John Bailey, managing director of S&P in Australia and New Zealand. Bailey says that in
February, S&P announced action to "further strengthen" its credit
ratings process, enhance its analytics and provide more transparency to the
market.
Moody's released an update last month on measures that it says settle the
concerns expressed by "both the private and public sectors",
including improving surveillance, separating non-rating and rating activities
to prevent conflicts of interest, and improving transparency.
Fitch did not respond to questions.
Perhaps the agencies' best defence, in the end, is the argument that
investors only have themselves to blame if they rely too much on ratings. They
are, after all, just that: credit ratings. They are not recommendations to buy
or sell. They are not audited opinions of a company's financial soundness.
"I don't think it's as simple as blaming the credit rating
agencies," Laubsch says. "We have to learn to ask, 'if there's extra
return, where is the risk?' And don't rely on any single information source;
get as many perspectives as possible."
Westpac chief executive Gail Kelly has not commented on the woes afflicting
Westpac's Melbourne-based competitor, NAB. But late last month, she made a not
so subtle reference to the situation. Kelly produced a note from November 2006
recording a discussion among Westpac executives about CDOs, and whether the
bank should invest in them.
Among the factors considered was Westpac's lack of knowledge about CDOs, and
the reliance on rating agencies that would result. Part of the discussion went:
"Product knowledge is important. Some of the asset classes mentioned are
not ones where we have a natural competitive advantage. Relying on the rating
agencies is one of the mistakes we've made in the past, where the minimum
rating of A- was not the protection we thought it was."
As Kelly observed, the investments were not made.