Select Committee on Treasury Written Evidence

Supplementary memorandum from Moody's

  This memorandum responds to the Committee's requests at the evidence session on 13 November 2007. I deal with each area in turn.


  As Moody's has indicated on previous occasions, we have an "issuer-pays" business model. In general, issuers pay for the ratings that we assign to their debt securities. We recognise that this model creates potential conflicts of interest that must be managed effectively. That is to say, if Moody's rates a given company and is paid by that company, then we must protect against the company's potential influence on the initial rating process and potential interference in future rating actions. The market broadly understands this potential conflict[21] and we believe that Moody's manages our business model to a global best practice standard.[22]

  In specific response to the Committee's concern about Moody's relationship with Northern Rock, we can confirm that Moody's has not provided consulting or non-rating services to Northern Rock. This assertion holds equally true for the subsidiaries of our corporate parent, Moody's Corporation ("MCO"). The only fees earned by MCO were for the provision of Credit Rating Services[23] by Moody's of which 95% was for the provision of credit ratings and 5% for the sale of related research.

  Because of confidentiality reasons and competitive concerns, we are unable to provide you with the exact fees charged to Northern Rock. However, Moody's assigned over the last five years first time ratings to Northern Rock, its subsidiaries or its related special purpose vehicles as follows:

    1.  Eight covered bond issues.

    2.  Twenty one structured finance deals principally relating to the Granite issuance programme.

  In addition Moody's had five distinctive fundamental ratings on Northern Rock PLC (Deposit, Bank Financial Strength, Short Term, Subordinated Debt and Hybrid).

  Moody's was paid rating fees for these ratings.

  To provide further context for the Committee, we note that the total fees earned by MCO from Northern Rock in 2006 accounted for less than 0.1% of MCO's total revenues.[24] Furthermore, in 2006, the fees earned from Northern Rock were significantly below the average and median fees earned by Moody's from other top 10 UK banks, as sized by total assets.[25]

  Moody's would not sacrifice our reputation with the investor community for providing credible and reliable ratings, which has been built over 100 years, for any rating relationship.


  For the information requested on ratings accorded to particular instruments and institutions, please see Annex 1.


  Moody's welcomes the Bank of England's important contribution to the current international dialogue relating to credit rating agencies. It is our understanding that these suggestions are considered to be ideas that merit consideration rather than reflecting the final position of the Bank of England.

  We set out below our current thinking about the Bank of England's suggestions. It would be premature, however, to provide the Committee with our definitive position on these suggestions because of the developing nature of the global dialogue on the role and function of rating agencies. In this regard, the Committee should be aware that Moody's is fully engaged with numerous market participants, including issuers, investors and regulatory authorities in exploring the appropriate set of responses to the issues arising from the current market turmoil.

Suggestion 1:  Rating agencies could publish the expected loss distributions of structured products

    "Agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them.[26] Agencies have made significant efforts over the past few years to increase the transparency of their rating methodology for structured finance products, through publication of research reports describing their modeling methodology and their assumptions on correlations and recovery rates. But published distributions could provide a visual reminder of the fatter tails embedded in the loss distribution in structured products."

  It is our understanding that this recommendation, if implemented, would ask for credit rating agencies to provide a simple metric that alerts the investor to the nature of the tail risk. Moody's already publishes much, if not, all of the relevant information necessary for assessing tail risk. Having said that, we appreciate that there is market interest in such a simple metric. We are currently exploring a number of possible approaches to this issue. At this point, however, we have not been successful in reducing such complex information into a meaningful metric and we are concerned that simple metrics might themselves be misleading. Nevertheless, we are working on means to improve investor understanding of the potential uncertainty that surrounds the expected credit performance of different rated securities. This work includes careful consideration of how we present our already available public information.

Suggestion 2:  Rating agencies could produce a summary of the information provided by originators

    "Agencies could provide a summary of the information provided by originators of structured products. Information on the extent of originators' and arrangers' retained economic interest in a product's performance could also be included. Such a summary may satisfy investors that incentives are well aligned or encourage investors to perform more thorough risk assessments."

  Credit rating agencies are one of many participants with historically well-defined roles in the structured finance market. Our role is fundamentally the same as the role we have played over the last hundred years in the corporate bond market: we provide a public opinion (based on both quantitative and qualitative information) that speaks to one aspect of the securitisation, specifically the credit risk associated with the securities that are issued by securitisation structures.

  Our credit opinions are based on information made available to us, which we analyse in accordance with our methodologies. The Committee should note that, in cases where we believe we do not have sufficient public and private information, our practice is either not to issue a credit rating in the first place or, following a rating committee deliberation, to withdraw a previously issued rating and make the reason for such withdrawal public in a press release.[27] Consequently, any enhancements in the quality and level of issuer information disclosure would, in turn, enhance the quality of our credit ratings. Because our role is that of a user of information provided by others, Moody's has always supported transparency, both in the corporate market and in the structured finance market.

  If authorities would like to increase the level and quality of transparency in the market by requiring that summary level data on a structured product and the level of economic interest in that product's performance is retained by the originator, we would suggest that rating agencies are not the appropriate entity on which to place such disclosure obligations. While we fully support the Bank of England's enhanced transparency recommendation, we believe that issuers are the logical entity to provide such information to the market. Our suggestion is based on several reasons.

  From a practical perspective, requiring rating agencies to disclose issuer-level information may have a detrimental affect on the quality of our credit ratings. Issuers provide certain information to us with the understanding that the information will be held in confidence. If they believed that credit rating agencies would disclose it to the market, the issuers might provide less information to us. This outcome could adversely affect the quality of our opinions, since they would be based on potentially incomplete data. More importantly, only the issuer has complete access to its own data and, consequently, only the issuer has the ability and appropriate expertise to assert that the summary data disclosed is an accurate and complete representation of its financial and economic status.

Suggestion 3:  Rating agencies could produce explicit ranges for their scores on probability of default

    "Agencies could produce explicit probability ranges for their scores on probability of default. Probability ranges would provide a measure of the uncertainty surrounding their ratings. Although such figures are already available retrospectively as transition matrices, an explicit probability range would allow investors to monitor agencies' performance when rating different asset classes".

  This suggestion seems very close in spirit to Suggestion 1. The suggestion invites the credit rating agencies to illustrate potential elements of credit risk that go beyond those envisaged by the rating itself. A Moody's credit rating is a probabilistic opinion about future events. Our opinions are by their nature the product of a range of probabilities based on our assumptions of various factors and expectations about a transaction's future creditworthiness. Furthermore, in many cases, investors can access models developed by Moody's. These models allow investors to change various assumptions and estimate the impact on a published rating. Consequently, we believe that there is a risk that, if we were to adopt this suggestion, it might lead to results that are inconsistent with the nature of our ratings. Having said this, there might be demand for us to provide some guidance on how widely we might expect the performance of pools of similarly rated securities within specific sectors to vary over time in the future.

  On the question of performance of our ratings, the Committee should note that Moody's already publishes idealised expected loss tables which, rather than indicating a range of loss expectations, identify an idealised target expected loss rate. This information already allows the market to measure our historical performance and the overall quality of our ratings.

Suggestion 4:  Rating agencies could adopt the same scoring definitions

    "Agencies could adopt the same scoring definitions. Currently, some use probability of default, some loss given default and others a combination. Converging on a single measure would reduce the risk of misinterpretation by investors".[28]

  Moody's believes that rating agencies should not be required to harmonise their processes, methodologies, rating opinions or rating definitions. Because credit ratings are forward-looking opinions about creditworthiness that address inherently uncertain future events, Moody's believes that there is no single approach that should be adopted for developing and publishing them. Two rating agencies looking at the same set of facts may legitimately reach different conclusions based on their individual points of view, understanding of market behaviour, or analytical methodologies. Moreover, capital markets constantly evolve, with changes in financial products, issuers and the credit environment. Measures that specify a particular approach may create a static, inflexible system. Even if initially aligned with market practices, such a system would require or promote harmonisation of rating opinions and could ultimately make rating agencies less capable of responding to innovations and meeting demands in a continuously evolving market. Over time, diversity of opinion would suffer, and the motivation and ability of rating agencies to compete on the basis of improving credit analysis would be materially eroded.

  We can confirm to the Committee that we are endeavouring to explore means of more clearly and transparently identifying the limitations and attributes of our credit ratings.

Suggestion 5:  Rating agencies could score instruments on dimensions other than credit risk

    "Finally, rating agencies could score instruments on dimensions other than credit risk. Possible additional categories include market liquidity, rating stability over time or certainty with which a rating is made. Clear scores on these dimensions could encourage more sophisticated investment mandates and easier monitoring of non-credit risks in a portfolio. It would clearly take some time and money for agencies to develop the necessary expertise on these other risks, but some agencies have already proposed these additions".[29]

  Moody's already provides several non-credit scores. Examples include those which assess operational quality of managed funds, alternative liquidity of corporate entities, and, as discussed in our evidence before the Committee, financial strength of banks. Recently we introduced a "fundamental value" product based on discounted cashflow analysis for structured finance securities. This product should also allow scope for volatility analysis based on changes to assumptions. We will continue to explore areas where we believe we can provide tools that would be useful to the market.

6 December 2007

20   When referring to Northern Rock we include any of it subsidiaries and all special purpose vehicles related to Northern Rock. Back

21   We would note that under an alternative business model in which bond investors rather than issuers pay for ratings, it is also likely that a large investor paying fees to Moody's would have an incentive to apply pressure to influence the rating process-especially an investor holding concentrated positions. Rating actions often have implications for an entity's equity valuation, and so investors who also hold equity positions may be doubly motivated to influence rating actions. Back

22   For a detailed discussion of the various policies and mechanisms we have in place that manage and mitigate the potential conflicts in our business model please see "Moody's Investors Service Report on the Code of Professional Conduct", April 2006 (hereafter "Moody's Report"). The report is available on our website, at: 

23   As defined in the Moody's Code of Professional Conduct: "Credit Rating Services are those products and services that are derived from the Credit Rating process and include, but are not limited to, the production and sale of Credit Ratings and related research, data products and related analytical tools". The Code is available on our website, at: Back

24   Moody's fees earned from Northern Rock peaked in 2005. This reflected the number of structured finance transactions issued by Northern Rock. The fees in 2005 were some 40% higher than in 2006. In 2002, 2003 and 2004 Moody's earned fees that were some 30%, 40% and 20% lower respectively than in 2006. Back

25   Northern Rock is a top 10 UK bank. Back

26   Bank of England footnote: "The risk that extreme losses are more likely than what would be expected from a normal distribution". Back

27   A decision to withdraw a rating is made by a rating committee. Language similar to the following typically would appear in such a press release: "The rating has been withdrawn because Moody's believes it lacks adequate information to maintain a rating. Please refer to Moody's Withdrawal Policy on". Back

28   Bank of England footnote: "Moody's announced in 2006 that it would start disaggregating some of its long-term ratings into their two key components-loss given default and probability of default
(, 22 June 2006)". 

29   Bank of England footnote: "Moody's is considering issuing measures of liquidity risk and market risk alongside traditional ratings for complex financial instruments (Source: Financial Times, 17 September 2007)". Back

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