Question time for rating agencies

Implications: Over reliance on ratings without doing your own home work is a recipe for disaster.Special status of the rating agencies comes under review as questions arise on access to information not available to other investors.

Analysis:  

Sub prime crisis continues to take its toll. Many have predicted worst is over, others have said it will take another year or so to achieve normalcy. Whatever, the crisis has thrown spotlight on the credit rating agencies and their role, for the first time. There have been countless ups and downs in the stockmarkets worldwide, in the past, but never a question raised about the workings of a rating agency nor a CEO of a rating agency put in papers.

Standard & Poor has named Deven Sharma to replace Kathleen Corbet as president after legislators and investors criticised the credit rating company for failing to judge the risks of securities backed by subprime mortgages. S&P and Moody’s Investors Service failed to downgrade bonds backed by loans to borrowers with poor credit until July, when some had already lost more than 50c in the dollar, calling into question some of the AAA ratings to securities.There are also concerns that the subprime mortgage defaults will slow demand for ratings of collateralised debt obligations (CDO). There have been rumblings in Europe at the way the crisis has panned out.There have been calls for investigation into rating companies, review management and resources of the companies. It is time the working of the rating agencies is brought under scrutiny as this crisis has highlighted the importance and excessive reliance on the rating agencies by institutions and investors and the capacity to create a worldwide crisis, loss of huge amounts and disruption to economic activity worldwide. Share prices of McGraw Hill and Moody’s have declined partly because of concerns that this crisis will slow demand for ratings of CDOs. Perhaps further changes to personnel and business is yet to come not only at S&P but also at other rating agencies as well.

Since the stockmarket crash of 1929, there have been periodic disruptions to the financial markets. However, it has become more pronounced since the last 20 years, for example, the Asian financial crisis in 1997, bursting of the dotcom bubble in 2000, 9/11/2001 attacks, collapse of Enron and now the subprime crisis. It is as if a crisis of this magnitude was waiting to happen.

The subprime mortgage crisis initially confined to US soon turned in to a serious international crisis, putting to doubt the creditworthiness of various Institutions.

The impact on the consumer confidence the current crisis had, has yet to be gauged. The housing sector had created a lot of ancillary economic activity and jobs and now the trend is on the reverse. Impact on a country’s economy will be known only when recovery starts. Results should lead to policy changes. However, the current crisis has brought into focus :

1. Rating agencies – large amount of debt was highly rated, which in the end proved risky and delinquent.

The argument is whether the crisis was triggered by weak analysis and who pays for the ratings. As investors tend to shop for the highest ratings. Therefore the question arises, whether investments should be made based on such ratings alone and how should such concerns be addressed ? Maybe the wings of the credit rating companies will be clipped and their role will be viewed with circumspect.

2. Non-Bank Financial Institutions (NBFIs) – How to address crisis created by NBFIs ? Would more monitoring and supervision resolve the issue ? Or should there be more subtle pressure from regulators such as Federal Reserve ? Because the current crisis is the handiwork of NBFIs rather than the banks due to poor underwriting standards for too long and loans have been delivered for the asking. This leads to the role of regulators. Should there be more supervision of NBFIs ? Because banks accept more supervision and hence conform to strict guidelines.

3. Government – It is everyone’s dream to own a house during their lifetime. The current crisis threatens that dream. What have the Governments done to channelise investments to housing sector ? Leaving it to private agencies to determine and fulfill those dreams has the potential to create a disaster.

Now is the time for the Government to move to correct the situation and play a leading role. Set out policy and guidelines. Regulators should monitor and supervise the markets regularly.

However, there will still be demand for the services of the rating agencies, but with a little loss of faith.