The ratings oligopoly

It says a lot about the power of credit rating agencies that a week after NAB blamed them for a $1 billion write-off of credit derivatives, the bank was preparing to go cap-in-hand to the agencies to defend and explain its capital strength.

NAB knows as well as any bank or company operating in global financial markets that the credit rating agencies play a crucial role as gatekeepers to capital markets and that it needs the highest possible rating to achieve cost effective funding.

The two agencies that dominate the world credit ratings business, Moody's and Standard & Poor's, have put NAB's AA credit rating on negative outlook. Both were looking to NAB to show stronger risk management, including managing the challenges presented by its portfolio of collateralised debt obligations, known as CDOs.

It is ironic that NAB is under the gun from the agencies for its failure to adequately manage its CDO risks at a time when the agencies are themselves under the gun for their failure to warn of the dangers of investing in a range of structured finance products including CDOs.

An example of how badly the agencies got it wrong was shown in October and November 2007 when Moody's downgraded 198 Aaa rated CDOs, including 30 downgraded by 10 or more notches to below investment grade. By way of comparison, since 1970 the maximum number of notches that Moody's has downgraded a corporate credit in one step is six notches.

Various inquires around the world have raked over the sub-prime crisis to examine the role played by various players including ratings agencies and what can be done to avoid the same thing happening again.

As recently as last week, the Basel Committee on Banking Supervision, released a report on credit risk transfer focusing on CDOs. It concluded that the credit rating agencies grossly underestimated the credit risk of CDOs by failing to capture the risks of a systemic decline in US real estate.

It said that although the agencies had reviewed their systems and changed their quantitative analysis, the changes were "narrow in scope and largely backward looking”.

No rating agency is willing to lift the lid on its "black box” despite a broad commitment to greater transparency and openness.

More than a year after the sub-prime meltdown began the ratings agencies have managed to maintain their privileged position in the global capital markets as not only gatekeepers to wholesale funding but partners of regulators in determining capital strength of banks and insurers.

In Australia, APRA uses credit ratings in the calculation of some fundamental ratios for general insurers. The use of credit ratings is mandated by the Basel II capital rules for banks. Ratings are also essential for the new accounting standard for financial instruments. There are no plans to change these rules, which critics say have given credit ratings the aura of being perfect.

It has been argued that regulatory endorsement of credit ratings is the one of the factors which encourages issuers to seek high ratings regardless of the rating quality. It removes the incentive for third party review of rating actions.

The agencies have managed to preserve their "issuer pays” approach to funding their businesses. They have maintained the protection provided under the First Amendment in the US, which means they cannot be prosecuted for opinions issued about companies whether issuer paid or unsolicited.

The oligopolistic structure of the industry looks set to remain intact with Moody's, S&P and Fitch Ratings enjoying a market share of 75 per cent. In certain segments S&P and Moody's rate 99 per cent of issues. There is competition from smaller ratings agencies in the US, Europe and Japan but they have complained that they cannot afford the increased corporate governance measures demanded in the wake of sub-prime.

A tougher code of conduct for credit rating agencies just released by the International Organisation of Securities Commissions suffers from the fact that is not policed by an independent supervisory authority. The credit rating agencies have the option of not complying with the IOSCO code of conduct as long as they explain why in their annual reports.

IOSCO has proposed that agencies reveal all clients that account for more than 10 per cent of their business. This demand follows evidence that only four or five issuers accounted for the bulk of the sub-prime bonds that went bad. Some have argued for the limit for one client disclosure to be set at 5 per cent.

A push by various industry groups in Europe and the US to force ratings agencies to have a separate rating or disclaimer on structured finance products is being resisted by the agencies. Fund managers also opposed this move because it may have altered the value of their existing portfolios of bonds or limited their ability to invest freely.

Meanwhile, corporations and bond issuers are still likely to engage in "rating shopping” to secure the highest possible credit rating.

The only serious threat to the continuation of the status quo for rating agencies is coming from the Committee of European Securities Regulators. The committee is conscious of the strong opposition in Europe to the power and influence of US ratings agencies, which are licensed by US regulators.

There was a similar groundswell of concern in Europe in 2002 in the wake of the Enron collapse, though that dissipated within a few years.

The US response to the credit ratings agencies' role in Enron was the Credit Rating Agency Reform Act of 2006. It attempted to reduce the barriers to entry to encourage greater competition.

That Act also restricted the SEC from regulating the "substance of credit ratings or the process by which they are determined”. That key clause will help protect the agencies from a radical sub-prime shake-up.