Conspiracy of convenience

The role of the big credit ratings agencies has been highlighted in discussion on Business Spectator this week. The conclusion? They are hopelessly and unavoidably conflicted but remain vital to the functioning of modern financial markets.

As Duncan Andrews, founder of Australian Ratings (now Standard & Poor's Australia) wrote in The ratings time-bomb and Brendon Watkins, a partner at law firm Minter Ellison made clear in Ratings agencies on the ropes made clear, there is a fundamental conflict in the agencies' reliance on issuers of the securities they rate to pay their fees. Equally, there is recognition that there would be no properly functioning securitised debt markets if there were no ratings.

With every man and his dog – the SEC, Congress, the European Commission, the International Organisation of Securities Commissions and others – now pouring over the role the agencies have played in the sub-prime debacle, it is apparent that the business models of the big agencies will have to change.

The agencies themselves are trying to head off regulation, and probably litigation, with self-regulation that mainly relates to the level of disclosure they make about the way their ratings are developed and the conflicts they incur.

It appears almost inevitable that the activities of the agencies will be curtailed and that there will need to be a quite fundamental change in their approach to rating securitised debt.

As Duncan Andrews noted, securitised debt markets and the sophisticated credit-enhancement techniques that evolved within them wouldn't have developed to the degree they have without the agencies and their ability to deliver reassurance to investors.

The business model for ratings agencies is built on the core conflict that they make their money from the organisations they rate. That's not dissimilar to the conflict faced by auditors, whose clients are the companies they audit.

Just as the big accounting firms were criticised and ultimately regulated in the wake of the Enron and Worldcom scandals for amplifying that core but manageable conflict with lucrative non-audit fee stream, the rating agencies have developed a business model that involves non-rating services.

The agencies not only consulted with issuers of the products they subsequently rated but even designed some of the products themselves. It is difficult to see how a rating could be objective in those circumstances, particularly when the income from structured finance ratings and consulting had grown to nearly half their revenue bases.

If it was regarded as prudent to limit the amount of non-audit work an accounting firm could do for an audit client, it would appear sensible to impose a similar restriction, even a prohibition, on ratings agencies, given their centrality to a modern financial system.

The other core issue relates to another conflict identified by Duncan Andrews – that the agencies and investors need to be able to rate large proportions of securitised debt as AAA. Otherwise a lot of investors can't invest, which would limit the size and depth of the market and the fees the agencies could generate.

The reality is that AAA means a minuscule probability of default – the kind of creditworthiness traditionally assigned to sovereign debt issued or guaranteed by the governments of developed nations. It shouldn't mean packages of sub-prime mortgages with lots of leverage that have been credit-wrapped by a monoline insurer with insufficient capital to withstand a severe market downturn.

It was convenient for everyone in the sub-prime markets to pretend there was no distinction while everyone was gorging on the fees the boom in credit markets generated. The whole concept of how securitised debt markets are rated, however, needs reappraisal in the wake of the meltdown.

There are number issues the experience has highlighted. One is that the agencies didn't analyse the risks of structured finance products they were rating sufficiently – in some instances relying on the underwriters' analysis of the risk of defaults.

Another is that credit enhancement is only as good as the enhancer. It is remarkable, and an indictment on the agencies, that they have been very, very reluctant to down-grade the bigger credit insurers – despite the reality that they are all teetering on the brink – for fear of the further damage that would do to securitised debt markets.

The core problem is that it has been convenient for the agencies, their clients, the development of the securitised debt markets and the exotic fee-generating structures within them, to pretend that these products could be as safe as a US or Australian government bond. It was a grand conspiracy of convenience.

In a mark-to-market environment it isn't sufficient that the risk of actual default by an issuer is low. Investors also need deep liquidity in an issue to be able to trade out of an exposure without significant risk of loss. There is no liquidity in most of the sub-prime debt products the agencies stamped as AAA not that long ago.

Either a whole new set of ratings will need to be developed to differentiate between traditional AAA-rated paper and credit-enhanced securities or the agencies are going to have to inject a lot more granularity and rigour into their existing approaches – and downgrade vast amounts of securitised debt in the process.