Select Committee on Treasury Sixth Report

7  Credit rating agencies: methods and conduct


190. Investor over-reliance on credit rating agencies and the information content of credit ratings were not the only criticisms made of credit rating agencies. During our evidence sessions, a large number of witnesses were concerned by two further issues:

How credit rating agencies reach their conclusions

191. How accurate the credit rating agencies were in the conclusions they reached is a live issue given, as discussed in chapter three, the large number of ratings agencies downgrades of asset-backed securities and, in particular, of securities backed by sub-prime mortgages in 2007. These downgrades, combined with write-downs and substantial losses suffered by a large number of financial institutions, resulting from their exposure to securitised products backed sub-prime mortgages, have turned the spotlight onto the methods used by the agencies to reach their conclusions.

192. Mr Drevon explained to us how Moody's rated sub-prime products:

our analysis is really statistically based because we are looking at very large pools, in the case of US sub-prime we are looking it more than 40 different pieces of data on each loan to come to a conclusion, and that helped us to understand the level of risk in each individual loan and then, based on that data, make assumptions about the credit risk of those pools. It is a very serious amount of work.[272]

193. The ratings agencies defended themselves against the charge that they made mistakes in the ratings they awarded securities backed by sub-prime mortgages by stressing the unexpected nature of the problems that emerged in the sub-prime housing market in the USA. Mr Bell, from Standard and Poor's told us that with respect to sub-prime "the future was much worse than even our worst case assumptions—the deterioration in credit, the deterioration in underwriting, the deterioration on the fraud side", adding that there was also "a series of unusual and completely novel patterns of behaviour by sub-prime borrowers". Mr Bell went on to say that "all of these combined to create a situation that was worse than our worst case assumptions and also completely novel," and that with hindsight "if we had known exactly what was going to unfold, we would have rated these transactions differently".[273] This point, that the scale of the problems in the US sub-prime market was totally unexpected, was repeated by Paul Taylor, from Fitch, who told us "what actually happened in the US sub-prime market was very much unprecedented. We had not seen anything like it before."[274]

194. A number of witnesses questioned the models used by the credit rating agencies to arrive at their conclusions. Sir John Gieve told us that "there is a question about whether they [the credit ratings agencies] went too far in relying on their models to put firm ratings against products which did not have an obvious market value … maybe those models were simply too limited to justify a firm rating".[275] Professor Buiter also raised a problems about the models used by ratings agencies to arrive at their rating results:

The first is the unavoidable 'garbage in—garbage out' problem that makes any quantitative model using parameters estimated or calibrated using past observations useless during times of crisis, when every crisis is different. We have really only had one instance of a global freeze-up of ABS markets, impairment of wholesale markets and seizure of leading interbank markets simultaneously in the US, the Eurozone and the UK. Estimates based on a size 1 sample are unlikely to be useful.[276]

Professor Buiter went on to question the extent to which it was technically possible for the agencies to provide accurate, impartial ratings:

the complexity of some of the structured finance products they are asked to evaluate makes it inevitable that the rating agencies will have to work closely with the designers of the structured products. The models used to evaluate default risk will tend to be the models designed by the clients. [277]

195. Ian Bell acknowledged that "clearly there are lessons that we are going to have learn about US sub-prime", going on to say that "we are looking at what went wrong and how we can possibly learn from this and how we can change our criteria, change our tools of analysis".[278] The ratings agencies have already begun to revise their methods in the light of higher than expected defaults on sub-prime mortgages. Changes include higher loss severity assumptions, more severe stress tests and increased monitoring of fraud prevention by lenders. However, the IMF concluded in its October 2007 Global Financial Stability Report that "even with these changes, there remain broader problems with the structured credit process rating methodologies and processes". [279]

Conflicts of interest

196. A final substantive area of concern with respect to credit rating agencies that emerged during our inquiry is the charge that the credit rating agencies are "conflicted". The charge that credit rating agencies are "conflicted" was made for two reasons. First, because the credit rating agencies are paid by the sellers rather than the buyers of the products they rate, which could influence the ratings they provide. The second concern is that the credit rating agencies provide additional services to the firms whose products they rate.

197. Michel Madelain from Moody's confirmed that in the ratings industry "fees are paid by the issuers of securities".[280] Mr Sants told us that the payment model used by credit rating agencies did result in a "conflict" and that it was necessary to ascertain what consequences flowed from such "conflicts".[281] Mr Madelain also acknowledged that the pay model used in the ratings business did create a potential conflict of interest but, along with other representatives from the credit rating agencies, believed that "conflicts" were well-managed. Mr Madelain said:

what we do believe is that we do manage that conflict effectively, as has been demonstrated by our track record in this area and also I think, as we have stated many times, by the importance of our reputation for the viability of the services we provide.[282]

198. Both Mr Madelain and Mr Bell stressed that reputational integrity was of crucial importance to the agencies, citing previous investigations of ratings agencies by the Committee of European Securities and the European Parliament which the agencies told us, "reached the conclusion that our conflicts of interest did not impact on the ratings we gave".[283] Sir John Gieve, when asked about possible "collusion" between the banks and the credit rating agencies, told us that "I think the ratings agencies' response to that is that their reputation and their future business depends on producing ratings which stand up in practice".[284] Professor Buiter told us that the credit rating agencies were "subject to multiple potential conflicts of interest".[285] He acknowledged that reputational considerations did help "mitigate the conflict of interest problem", but stressed that reputation alone could never eliminate the problem because:

even if the ratings agencies expect to be around for a long time (a necessary condition for reputation to act as a constraint on opportunistic and inappropriate behaviour) individual employees of ratings agencies can be here today, gone tomorrow. A person's reputation follows him/her but imperfectly. Reputational considerations are therefore not a fully effective shield against conflict of interest materialising. [286]

199. The second "conflict of interest" highlighted by witnesses was that the credit rating agencies provide additional services to the firms whose products they rate. This is a potential concern if these additional services are used to assist issuers of securities in achieving investment grades for their products. Mr Pitt-Watson emphasised his concern that credit rating agencies "would provide additional services to the company of all sorts".[287] Professor Buiter also argued that credit rating agencies were subject to potential conflicts of interest on these grounds:

They are multi-product firms that sell advisory and consulting services to the same clients to whom they sell ratings. This can include selling advice to a client on how to structure a security so as to obtain the best rating and subsequently rating the security designed according to these specifications. [288]

200. We asked representatives from the credit rating agencies whether they provided such advisory functions to clients. Representatives from the credit rating agencies denied that they provided technical assistance and advice on how to design structures to attract the best possible rating.[289] They stressed that different parts of the business provided such assistance and advice and were separated from the rating side of the business. Mr Drevon told us that "we do provide some additional tools to the market, but those are done separately, they will be done separately from the ratings agency".[290] Barry Hancock said Standard and Poor's adopted a similar approach, whilst Paul Taylor from Fitch informed us that Fitch Ratings did not provide these services, although he added that "we have a sister company, which is a completely different company".[291] When questioned as to whether there were Chinese walls between sister organisations, Mr Taylor replied, repeating his earlier answer, that it is a different company which provided those services.[292] Mr Madelain stressed that such services "are unrelated to ratings".[293] Professor Buiter disagreed, telling us that "even the sale of other 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".[294]

201. It is incumbent upon the credit rating agencies to provide further reassurance that conflicts do not exist between their advisory and rating functions. If the credit rating agencies fail to demonstrate that Chinese walls alone are a sufficient safeguard then it may be necessary to look at alternative approaches to tackling this problem.

202. The Bank of England's proposals discussed in the previous chapter aim to facilitate a more sophisticated use of credit ratings by investors. They do not, however, address the "conflicts of interest" issue discussed above. Witnesses to our inquiry were clear that further reforms in the way credit ratings agencies operated were necessary to help tackle the issue. Angela knight believed it was important to tackle to address the "conflict of interest" issue: "I think there is something about the separation of the provision of ratings from the financing of the agencies that is important" [295] The Investment Management Association did not favour a regulatory approach to tackling "conflicts of interest", but instead argued that the credit rating agencies "should put in place policies and procedures to identify, manage and, where incapable of being managed out, disclose conflicts inherent in their individual business models".[296] Professor Buiter's solution to the "conflict of interest" resulting from the provision of additional services was for the ratings agencies to:

become "monolines", basically agencies just doing one activity, just doing ratings. You cannot manage the potential conflict of interest involved in advising a client on how to design a structured financial product to get the best possible credit rating and then rate that same product. That is going to create a conflict of interest so it should just not be possible to do that; you rate and that is it.[297]

Professor Wood agreed with Professor Buiter's proposal that the agencies should become monolines, telling us that it was surprising that "the agencies have not grasped that for themselves and set up separate ratings agencies because these would attract customers".[298]

203. Lord Aldington, whilst acknowledging that potential "conflicts of interest" did exist under the issuer pays model, pointed out that:

this debate about ratings agencies has been going on for years and years and nobody has yet found a better solution as to how to pay or compensate the ratings agencies.[299]

Mr Sants expressed similar concerns, telling us that it is not obvious that without that issuer pays model the credit ratings agencies "would be able to continue to thrive commercially and exist".[300] Sir John Gieve said that he would welcome a situation where investors could sponsor a rating agency where the ratings agencies "were being paid by the people they were supplying the service to". Sir John acknowledged that an investor-pays model had thus far "not proved possible as a business model", but went on to tell us that he "would not be surprised if some of the investment bodies consider that again".[301] Professor Buiter argued that payment by the issuer needed to end and suggested a number of ways forward:

Payment by the buyer (the investors) is desirable but subject to a 'collective action' or 'free rider' problem. One solution would be to have the ratings paid for by a representative body for the (corporate) investor side of the market. This could be financed through a levy on the individual firms in the industry. Paying the levy could be made mandatory for all firms in a regulated industry. Conceivably, the security issuers could also be asked to contribute. Conflict of interest is avoided as long as no individual issuer pays for his own ratings. This would leave some free rider problems, but should get the rating process off the ground. I don't think it would be necessary (or even make sense) to socialise the rating process, say by creating a state-financed (or even industry-financed) body with official powers to provide the ratings. [302]

204. We are deeply concerned about the conflicts of interest faced by the credit rating agencies and agree with Professor Buiter that the credit rating agencies are subject to multiple potential conflicts of interest. These conflicts of interest have undermined investor as well as public confidence in the rating agencies and must be tackled as a matter of urgency. Without reform the credit rating agencies will be unable to regain public trust and confidence. It is therefore incumbent upon the ratings agencies as a matter of urgency to demonstrate that they can effectively manage and be seen openly and transparently to manage the conflicts of interest in their business model out of the system. To this end, the credit rating agencies must put in place policies and procedures to identify, manage and, where incapable of being managed out, disclose conflicts inherent in their individual business models If they are unable to do this then new regulation will have to be seriously considered.

205. Professor Buiter and Sir John Gieve both suggested to us that the conflict of interest problem could be tackled if investors paid for ratings. However, this may merely serve to encourage conflicts in the opposite direction. For example, if investors paid for ratings they may have an incentive to bargain down ratings so as to maximise their rate of return. This suggests that it may prove difficult to remove such conflicts of interest simply through moving to an investor pays model and that the priority should be to ensure that a robust framework for managing conflicts of interest is put in place.

Increasing competition within the ratings industry

206. The issue of increasing competition in the ratings industry was raised by a number of witnesses to our inquiry, including Professor Buiter, who told us that "competition in the rating process is desirable" and that "the current triopoly is unlikely to be optimal". Professor Buiter argued that entry for new firms into the industry would become easier if the ratings agencies became single-product firms, although he cautioned that, for new firms, "establishing a reputation will inevitably take time".[303] The Investment Management Association concurred that greater competition was desirable, telling us some of the possible benefits: "the IMA remains of the view that more competition in the ratings process will encourage a higher level of analytical input and thereby improve the quality of ratings overall".[304] The IMA cautioned, however, that registration or regulation of ratings agencies could have the unintended consequence of raising barriers to entry to the industry.[305] Interestingly, representatives of the credit ratings agencies also agreed that an increase in the number of ratings agencies would be desirable.[306]

207. We are not convinced that the credit rating agency market is sufficiently competitive or efficient. At present the market is dominated by the two big US ratings agencies, Moody's and Standard & Poor's plus the European agency, Fitch. We therefore call upon competition authorities to examine what barriers to entry have prevented greater competition in the industry and how competition within the industry could be encouraged.

Monoline insurers

208. As we noted in chapter two, the monoline insurers have also played an important role in securitised markets. They provided third-party insurance or other financial guarantees to protect investors in securitised markets against loss. The continued deterioration in structured credit markets and, in particular, in securities related to US sub-prime mortgages has increased the potential for higher than expected claims to emerge. This has prompted pressure for credit rating downgrades of monoline insurers. Downgrading of the ratings of the monolines can occur when claims reduces a monoline's capital buffer to below the minimum required to maintain its rating. For example, one of the largest monoline insurers, Ambac Financial Group, announced a fourth quarter 2007 net loss of $3.255 billion and has since been downgraded by Fitch ratings.[307] Other large monoline insurers are also at risk of downgrades. As a result, the monoline insurers have been forced to seek extra capital to ensure that they can meet their obligations amidst the risk that otherwise they could lose their triple A rating. The consequences of a monoline downgrading would have wider market consequences, as the FSA explained in their January 2008 Financial Risk Outlook:

If a monoline is downgraded, the ratings of the securities insured by the monoline would also be at significant risk of downgrade. This could have wider market consequences and potentially result in the reduction in the credit quality of portfolios, and where portfolios are required to have minimum credit quality, forced selling.[308]

We expect to continue to monitor the role of monoline insurers and the risks associated with the problems they face.

271   Q 297  Back

272   Q 999 Back

273   Q 992 Back

274   Q 991 Back

275   Q 96 Back

276   Ev 313 Back

277   Ibid. Back

278   Q 1000 Back

279   IMF, Global Financial Stability Report, October 2007, p 9 Back

280   Q 969 Back

281   Q 1487 Back

282   Q 963 Back

283   Q 983 Back

284   Q 95 Back

285   Ev 313 Back

286   Ev 313 Back

287   Q 1385 Back

288   Ev 313 Back

289   Qq 952-957 Back

290   Q 958 Back

291   Qq 959-960 Back

292   Q 961 Back

293   Q 962 Back

294   Ev 314 Back

295   Q 1585 Back

296   Ev 291 Back

297   Q 930 Back

298   Q 931 Back

299   Q 1249-1251 Back

300   Q 1487 Back

301   Q 1700 Back

302   Ev 313 Back

303   Ev 314 Back

304   Ev 291 Back

305   Ev 291 Back

306   Q 1028 Back

307   Ambac Financial Group, press release, 22 January 2008 Back

308   , FSA, Financial Risk Outlook, January 2008, p 58 Back

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