Paul Taylor reaches into a folder of papers. "Cue another prop,” he says. The chief executive of Fitch Ratings, the number three credit rating agency, brandishes a report his analysts recently put out entitled "Bond bubble threat for US corporate bond investors”, which warns that there could be significant losses across the financial system if interest rates rise and bond prices go south. It is the latest in a string of "big picture” publications designed to persuade us that Fitch is thinking big thoughts, that it is taking a bird’s-eye view of the world economy and that it is not the type of company to miss, say, a whopping financial crisis in the making.
"We have a lot of internal debate,” he says. "I could give you all kinds of internal discussion, emails and documents from 2004 about the US housing market. None of that was ever published as research – and at the end of it we didn’t follow it, we got it wrong. But had we had some kind of report out at that point saying, ‘we’re concerned about this, we’re not sure, we think about it, there’s some tail risk going on here’, then we’d have been in a far better position than we currently are, because we wouldn’t be seen as quite so silly as people think we were.”
Rating agencies’ outsized role in the credit crisis is well known. By validating the transformation of subprime mortgages into triple-A rated securities, based on mistaken assumptions about the US housing market, they contributed to the infection of the global financial system.
The public and political opprobrium has been intense, with much of the blame laid at a central conflict of interest in the agencies’ business model, namely that they are beholden for their revenues on the issuers of the debt they are judging. Their high-impact downgrades of sovereign debt in Europe and the US have made them even more unpopular.
Yet one by one, ideas for radical reform of the industry have failed. Issuers still pay the bills and still get to pick which agency rates their debt. Power is still concentrated in the big three agencies – Standard & Poor’s, Moody's and Fitch – that rate 96 per cent of all the world’s bonds. And attempts to strip credit ratings of their central role in financial regulation are proving complicated. So why does the post-crisis landscape look such a lot like it did pre-crisis? Critics of the industry point to intense lobbying by rating agencies and Wall Street more generally, as powerful market actors assert their self-interest.
But there is an alternative view, recognised by some of the smaller rating agencies who hope to gain from the discomfort of the big three, which is that many mooted changes foundered on the rocks of impracticality.
Executives at the leading agencies say the need for radical change was always based on a false premise.
"That conflicts of interest led to inflated ratings at Moody’s is a concept I categorically reject,” says Raymond McDaniel, the agency’s chief executive. "One way to try and answer this is to make the argument in the negative. Why would it affect only housing and why would it affect only mortgage securities?”
While the assumptions about ever-rising house prices were wrong, other Moody’s ratings on complicated structured finance products, based on different assumptions about how many people would pay their credit-card bills or make good on their car loans, performed well over the deep recession, he said. Fitch and S&P make a similar point.
In the US, a senate committee found that credit rating agencies "at times gave into pressure from the investment banks and accorded them undue influence in the ratings process”, but no evidence that has led to any action by regulators. An Australian court, finding against S&P, said a "reasonably competent” rating agency could not have given a triple-A rating to mortgage-backed securities that the judge described as "grotesquely complicated”, but in the US and Europe agencies have so far largely been successful in fighting off liability for the fallout from faulty ratings.
Rating agencies’ processes for managing conflicts of interest are now more closely scrutinised following a demand by the G20 in 2009 that they be brought under the oversight of regulators. Nine agencies are formally registered in the US and 20 in Europe.
Outside the big three there is consternation. Smaller rivals fear that the cost of new rules is entrenching the status quo, making it ever harder to shake up the industry.
"It’s hard for anybody to complain too loudly about all this new, relatively onerous regulation because it’s pretty obvious why we are finding ourselves in this situation,” says Dan Curry, president at DBRS, Canada’s dominant rater, which has been trying to build a bigger global footprint. "We tried to politely point out to regulators that they designed all this regulation looking at, particularly, Moody’s and S&P, and a lot of these smaller agencies are going to get caught in the crossfire. Everyone’s saying they’d like more competition but what you’re doing is impeding competition and creating big barriers to entry.”
According to executives at the big three companies, they are entrenched for a reason: reputations and analytical prowess built up over generations. S&P traces its history back to 1860, when Henry Varnum Poor published his History of the Railroads and Canals of the United States; John Moody & Company published Moody’s Manual of Industrial and Miscellaneous Securities in 1900. Fitch, established in 1913, thinks of itself as a hungry young challenger, and the best horse for those looking to back competition in the industry.
McDaniel is sceptical that the industry can sustain many more actors. "There were eight or nine agencies back in the late 80s and early 90s. They had a choice to compete or to sell out, and they chose to sell.”
On both sides of the Atlantic, reformers have pushed an idea they say will deal with the conflict of interest at the heart of the "issuer pays” business model and encourage more competition for the big three. The idea is that there would be an independent body to stand between the issuers of asset-backed securities and the rating agencies, assigning work on new issues to agencies in rotation or according to expertise. Smaller rivals that might otherwise find it hard to persuade issuers to use them will be able quickly to build a record of ratings.
However, a reform package unveiled in November by Michel Barnier, EU commissioner for financial services, limited the idea to so-called resecuritised products – instruments that have all but died out since the financial crisis.
In the US, the idea of a central rating assignment body is being championed by Senator Al Franken, but a Securities and Exchange Commission report last month sounded sceptical. It spent 390 words on the benefits of the idea and 1700 words on the drawbacks, and recommended only that there be more discussion.
"This is the easiest way to make sure there is no conflict of interest and to break the oligopoly,” Franken said. "Unless it is addressed, people are going to get hurt again and the whole economy is going to get hurt again.”
In some areas of the market, there are stirrings of greater competition. When it comes to ratings on new commercial mortgage-backed securities, instruments made out of parcels of loans on office blocks and retail parks, you are as likely to find newcomers Kroll, Morningstar and DBRS as you are S&P, which withdrew from the market for a year while it fixed mistakes in its ratings model.
Yet for all DBRS’s progress, and even if the Franken plan were to be implemented, Curry cautions that it will be a long time before newcomers nibble any significant market share from the big three. "Even something that looks like a big change is going to actually cause things to change gradually over many years,” he said.
Quarantining banks from another agencies error
There is at least one other big item on the reform agenda that is being implemented. The G20 urged regulators around the world to stop relying on credit ratings for judging the safety and soundness of the banks and financial companies under their purview. So what if S&P and Moody’s decide that the assets on a bank’s balance sheet are investment grade? Regulators should come up with other ways to decide how risky an asset is and therefore how much capital a bank must hold in reserve in the event of losses. The idea is to reduce the importance of credit ratings to the overall financial system and to make sure there is less damage the next time that the agencies miss, for example, a whopping crisis in the making.
However, it has proved easier to wipe away references to credit ratings than it has been to decide what to replace them with.
The Bank for International Settlements, writing new international capital requirements known as Basel III, is consulting on complicated rules governing how banks can use their own internal models for deciding the credit risk of structured finance assets. It recognises, however, that some smaller institutions will not be sufficiently sophisticated to do this and will instead have to rely on rating agencies after all.
Some work by the UK Financial Services Authority has found that banks’ own models, relative to external credit ratings, will sometimes understate the risks.
Larry White, the New York University professor who argued for eliminating ratings from prudential regulations, admits it is hard work. "You need more regulators, you need them to be well paid and you need them to be respected.”
It is at least work that the rating agencies themselves profess to welcome. None wants their ratings to be treated as gospel; none wants downgrades to cause shockwaves through the financial system because of automatic triggers in capital rules. They just want to be seen making an honest, educated and hopefully more successful job forecasting the future.
"I don’t want to give the impression we haven’t changed,” Fitch’s Taylor says. "We’ve changed lots. We’ve changed people, we’ve changed process where we’ve needed to, we’ve got a lot better at publishing more information. But I don’t want to just sell that point. The important point is lots of what we were doing was working absolutely fine and has continued to work fine. And one of the reasons I feel a bit sorry for ourselves is, if you look at the people who use our product, if you look at our customers, they know that.”
Copyright the Financial Times 2013.