Credit rating agencies need to clean up act
Much has been made of the role played by investment banks in the events which led to the global economic meltdown. Now, the big credit rating agencies are also deservedly coming under the microscope. They played a key part in the sudden loss of confidence in the financial system and should bear a fair share of the responsibility.
The crisis has already changed the financial landscape beyond recognition, with the disappearance of the investment banks. But the major ratings agencies remain. They were instrumental in leading investors to misplace their trust in debt products containing toxic assets that defaulted and triggered the freeze in credit markets. Their role should be subjected to scrutiny. Seen through the eyes of former senior employees, this issue is featured in Behind the News on page 15 of this newspaper. Their accounts of how ratings were determined provide an interesting background to sweeping downgradings of securities by the two main ratings agencies. Up to last month, according to an analyst with UBS securities in New York, Standard and Poor's had downgraded 84 per cent of the investments in asset-backed Collateralised Debt Obligations it rated in 2006 and last year, including 76 per cent of those it gave a triple-A rating. Moody's has downgraded 90 per cent and 85 per cent respectively. To put that in perspective, only a handful of American industrial companies have that rating, yet last year S&P rated as triple-A nearly 1,300 securities or financial derivatives.
Deregulation and financial innovation involving such products gave rise to the excessive leverage and debt debacle. Now, regulators and lawmakers are pondering closer supervision of the market. Reining in the credit rating agencies, though, is more problematical. They are, after all, paid by the sellers of securities rather than their buyers. S&P and Moody's were competing for the business of sellers when they issued all those triple-A ratings.
Proposals to tighten standards at the agencies are welcome, but they do not tackle this fundamental conflict of interest. Investors are therefore ill-advised to rely on ratings alone until the market finds a way of resolving the problem.
Corporations that raise money on the international market usually need their debt rated by an agency recognised by the United States' Securities and Exchange Commission. There are only three, including the smaller Fitch Ratings. It is not practical to have either a government agency or independent auditor vet credit ratings. The agencies, therefore, have a responsibility to investors globally to be seen to exercise independence. S&P and Moody's say they are developing tougher requirements to more accurately evaluate and monitor debt. One of them should be much greater transparency in the ratings process.
Confidence in the independence and objectivity of credit rating agencies is not only important to trust in the global financial system. The next big market is carbon trading to combat global warming. Investors, dealers and financial engineers already envisage carbon-rating agencies assessing projects packaged for global marketing in the same way banks pooled mortgages and packaged them as asset-backed securities. It all sounds familiar. For the sake of its future, the world can ill-afford a carbon bubble and bust.
The US government's plan to save the financial system through a US$700 billion buyout of bad debt aims to restore confidence. Getting the big credit rating agencies to clean up their act can only help that process.