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The rating game

Rating agencies have come under intense attack over their failure to sound a warning before the US sub-prime mortgage crisis and last week the Treasury select committee grilled them over their role in the debacle.

Professor Willem Buiter, a former Bank of England monetary policy committee member and currently a professor at the London School of Economics, criticised Standard & Poor’s, Moody’s and Fitch Ratings when he was called as an expert witness at the meeting.

In a memorandum to the select committee, Buiter pointed out that rating agencies provide estimates of default risk. Even if default risk is absent, market risk or price risk can be abundant.

He explained that liquidity risk is one source of price risk. As long as it does not mutate into insolvency risk, liquidity risk is not reflected in the ratings provided by the agencies.

He said the fact that many “consumers” of credit ratings misunderstand the narrow scope of these ratings is not the fault of rating agencies but does point to a problem that needs to be addressed.

Buiter said: “There has to be an education campaign to make investors aware of what the ratings mean and do not mean. Second, the merits of offering and requiring a separate rating for, say, liquidity risk should be evaluated.”

But Homefunding chief executive Tony Ward says: “For mortgage-backed security deals, the investors are professional and should not need their hands held in this way. My experience is that entities always carry out their own credit assess-ment independently of the rating assigned to bonds. It sounds likely in relation to the US sub-prime market, that this was not rigorous enough.”

At the select committee meeting, chairman John McFall said rating agencies have failed hopelessly to ensure that investors are fully aware of what their ratings stand for and were slow to react to the Northern Rock fiasco.

McFall attacked S&P, Moody’s and Fitch for failing to make it clear to investors that their ratings should not be seen as a green light to buy securities and criticised them for not downgrading Northern Rock until September.

The Mortgage Practitioner sole practitioner Danny Lovey says the rating agencies got it wrong. “They obviously did not have their eye on the ball with Northern Rock but this does not mean they always get it wrong,” he says.

Buiter also suggested that rating agencies face conflicts of interest when selling services other than ratings. “The potential for conflicts of interest when a rating agency sells consultancy and advisory services is inescapable and unacceptable. Even the sale of products and services that are not inherently conflicted with the rating process is undesirable because there is an incentive to bias ratings in exchange for more business in functionally unrelated areas,” he said.

He pointed out that payment by the issuer for ratings should be ended and suggested that one solution would be to have ratings paid for by a representative body for corporate investors financed through a levy on firms in the industry.

Ward says his own experience of dealing with all three major rating agencies is that they do a professional job and do not compromise on their analytical work when assigning a rating because a firm has paid for it.

He says: “I have seen situations when a rating agency decides to shadow rate a transaction. This is where it decides unilaterally to rate it even though the agency was not appointed by the issuer. Moody’s has done this in the past.

“Usually, a shadow rating is harsher than the official rating, which may appear at first glance to support the view that, in an independ-ent role, they are more vigorous but, in fact, it usually merely shows that as unofficial rater it did not have access to all the facts.”

Lovey says: “You pay them as the issuer to rate your bonds and therefore it could be claimed there is a conflict of interest as they may well have other financial dealings with you.

“I think there is a case for having a Chinese-wall-type rating system, so there cannot be any claims of a conflict of interest or undue financial pressure. That is not to say I agree with the comments about a levy on firms. The seller should pay the costs of the sale of the bonds, not the market at large.”

Lovey says everybody needs to do their own due diligence, with caveat emptor remaining the principle of any market.


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