Rating Agencies Roundtable 2007: Part 3
IFR: If regulators worldwide rely heavily on the agencies, should they maybe not bear some of the costs?
Theodore: Some of them (the regulators) pay for subscriptions to certain services, but in answer to the initial question of whether a rating agency should take the role of the regulator, my answer would be: if this is a passive process, there is nothing you can do. If a regulator chooses to use the rating and regulations, this is not an outcome that a rating agency should necessarily be looking for, but it is one that it should accept. There is no other way.
But what I am really against is for the rating agency to take the role of the regulator and to try to second-guess it, and there are some instances in the rating process where this indeed is happening. A rating agency is not equipped or empowered to be a regulator and does not have their responsibilities or liabilities. It should simply avoid trying to play the role of a regulator.
IFR: On the question of self-regulation, could that be construed as the refuge of a body worried about what external regulation might throw up?
Theodore: This was a very important issue a few years ago, and, for the time being, it was sorted out: the rating agencies will continue to self-regulate and to respond to the challenges. The rating agencies themselves have since improved their transparency and have published methodologies explaining the basis for their ratings, and so there is no point for a regulator to second-guess what we do, and make us do a better job, because we cannot do a better job than "what you see in a transparent manner is what you get".
Possibly the threat of external regulation has acted as a catalyst for the rating industry to get its act together, which is I think a positive step. But at the same time, to expect that we will have an external regulator second-guessing each rating decision, each analytical report and each vote in a rating is perhaps going too far.
Liehr: This brings up the issue of competition again. If an agency gets it really wrong and investors are unhappy about a decision, ultimately they can move to another one, although the problem we have is, that if it is S&P or Moody's that got it wrong, there is still no real alternative in the eyes of many investors.
They do not feel they can simply decide to go with Fitch and get rid of the S&P or Moody’s ratings and regulations and replace them with Fitch’s. This is similar for the issuers as well. What you normally see in industry, if somebody gets it wrong, is that people move to the competition but, so far, it is not happening here.
IFR: Would an issuer ever approach somebody who might rate them lower, just because they think their methodology is more valid?
Aucutt: Probably not, but do we not want to go down the route whereby rating agencies are regulated by an external regulator and then feel compelled to be more cautious and come out with tranching and ratings that are going to be verging on the ultra-conservative, because they may need to justify themselves. They are not going to be aggressive or dynamic in any way, and this would probably stifle the competition, because we would bring everyone down to a far more level playing field, or a far more homogenous way of rating.
Ganguin: Generally speaking, what we have now in Europe is that, after a long consultation, the view is that rating agencies should not be regulated. In the US they have taken a different stance with the Credit Rating Agency Reform Act, but what is clear in both cases is that they want to ensure that the agencies are doing a good job and that we offer a quality product in that we deal with the conflict of interest and confidentiality issues. They also want to ensure that there is a consistent application of our methodologies. They do not want to get involved in second-guessing or auditing the outcome of the ratings, and they are saying that explicitly. There would be a real danger in doing that because if this happened we would be forced to be extremely conservative, which would bring a huge negative bias into the market. So I think that what is proposed now is to ensure that there is some competition but we can also have a quality product.
IFR: Do you think we are lacking in a consistent application of methodologies in Europe to a certain extent?
Ganguin: I cannot speak for the other rating agencies, but I can speak for ourselves. I think that, as someone indicated earlier, it has created a huge incentive for every player in the market to make sure that they have consistent processes, that the wires are crossed both geographically and across businesses as well as asset classes. I think that we should make sure that the ability to do post-mortems should exist, as there are likely to be issues that will be raised which may need to be discussed.
I think that it has been mutually beneficial, from that standpoint, in ensuring that we have a product of high quality. Also, in terms of transparency, to ensure that investors and issuers really understand the treatment of their accounts and their businesses.
Kent Kershaw: As a rating agency user, I would say, there is not always consistency, particularly between Europe and the US. In fact, there are a number of inconsistencies that come up. For example, we as a firm bring private placements which in the US are NAIC rated, suggesting an investment grade. When we ask the agencies to rate them privately in Europe, they consistently come up with high-yield. So, in Europe the agencies tell us private placements are in the high-yield, Double B, Single B area, and in the US the NAIC tells us they are investment-grade, how does that work? In the US the ratings agencies rate the security companies, which have 40 or 50 per cent investment-grade underlying assets and they make an assumption about the portfolio. So, in the US, they assume those very same assets are all investment-grade. When we ask them to rate these assets in Europe, they tell us they are all high-yield. When we ask them to explain the difference, and what has happened to the ratings since crossing over the Atlantic, no-one touches the topic.
Hunter: Is this for the same names?
Kent Kershaw: Yes, well, it is looking at the same portfolio. So when the agencies look at the portfolio, but they do not drill down into the names, they say that it is an investment-grade portfolio. But, when we give them a selection of names and say, "We would like you to drill down and look at these individual names," 95 to 100 per cent of those names come back as Double B and Single B. And, when we have said, "Please explain how those names have suddenly dropped six notches mid-Atlantic", nobody at these agencies can explain.
Madelain: What I can tell you is that we apply the exact same criteria in the corporate space, which is the area I work in, both in the US and in Europe. We have the same credit explanations. I do not know the exact details of the situation you mention, but I would be more than happy to look into it. I think you are referring, not to most of the assets that have been audited by Moody's, but the effective ratings that have been assigned by the NAIC.
Kent Kershaw: No, what I’m saying it that Moody’s insurance analysts in the US make an assumption about a portfolio, and when its corporate analysts rate that same portfolio in Europe, it comes out six notches different.
Madelain: But the Moody's insurance analyst does not make a judgment on the portfolio of corporate assets that its insurance company owns. He does not do that. What you are saying is that effectively, there is a difference of view between the rating methodologies in the NAIC system rating scale and what Moody's say. So what I think you are saying is: how come the insurance analyst at Moody's does not recognise that difference? That is how I understand your point.
Purely from a corporate point of view, a corporate rating point of view, the assets should be rated the same in the US as they are in Europe because we are using exactly the same methodologies.
Kent Kershaw: And that is exactly what we say does not happen. But I do not want to get bogged down in that point, suffice to say that the point I am making illustrates a clear example that the US and Europe are not completely in line.
Madelain: I would dispute that point.
Liehr: I mean, sometimes I think -- sometimes we wonder whether the regulator should actually rate the agencies and give a list of recommendations on which agencies you should go with, and which is safe and which is not. Here, I am not talking about the individual ratings they give, the opinions, but how they get arrive at those ratings.
Hunter: They do that, in the US they have the NRCO and in other countries around the world, there is the option to recognise agencies for Basel II purposes.
Liehr: I think I would probably go further and say “I do not know why you don’t actually further and give the rating agencies marks,” rather than simply saying "They are qualified, they are unqualified, this is a top agency, this is maybe not a top agency".
Hunter: Based on the performance of what?
Liehr: On everything, the performance they provide. Fitch, for example, I hear that time and again – especially from investors – that you have a very good dialogue, that analysts are available, so I think, you know, there would be a lot of different aspects going into the assessment mix. So why not have that?
Theodore: But that would imply that the rating agencies would need to be audited by regulators.
Liehr: They would have to be assessed one way or another.
Theodore: I mean to some extent in France, you guys probably know better than I do, the regulator issues a report on rating agencies, where it expresses its views on their activities. So it is not full regulation, it does not give grades, but it does have words about what has happened and the activities of rating agencies, which I think is a very positive step.
Ganguin: And in the US we would be audited, it is a sure thing.
Hunter: But at the same time the important point is staying away from the idea of direct contact. But it is interesting, the regulators have subcontracted the idea of recognition effectively by saying, “You need to have 10 qualified institutional buyers so that they are happy to use your ratings”. So, the whole argument of credibility, which was one of the sticking points on Basel II for a number of people, has effectively been outsourced. So really what the SEC is looking for is the procedures you have. It will then know, if it comes in and look at your procedures, it will want to be able to see that the rating agencies are being consistent.
IFR: There are other inconsistencies as far as securitisation is concerned. If you look at the performance between RMBS in the US and Europe, you will find that the US performance is far worse, yet the credit enhancement levels are roughly the same or similar. Why is that?
Hunter: As far as I am aware, and we have reviewed our RMBS portfolios, the credit enhancement levels are suitable for that category. But what you will find in the US is at the sub-prime level credit enhancement is vastly in excess of what it is in Europe. So you can have the same credit analysis, but if you are getting more defaults well then you are going to have a larger proportion of credit enhancement.
Aucutt: I think that is right. The US is an absolutely massive market and the UK is a reasonably sized market, but there is nothing like the same aggressive origination techniques. I think the sub-prime ratings in the States are very different to the UK. If you look at the non-conforming sector in this country, you will see ratings are different, and a lot of them are not banks, so they are doing it for different reasons, they are not doing it for capital relief, they are doing it for funding.
Ganguin: I would also be surprised if there were large differences in ratings. There must be other elements in there as well, because the models that are utilised on either sides of the Atlantic are the same and the legal requirements are the same. I do not think the data issue is really the big one. I would suspect there may be other differences in the actual structure.
IFR: Dagmar, have you noticed any difference between the credit enhancement levels in performance between the US and Europe in the pools of RMBS?
Kent Kershaw: Well, it is fair to say that the rating volatility within CDOs and structured credit is greater in certain asset classes and has been greater in the US compared to Europe. But that is really due to the different characteristics of the underlying assets. Does the rating structure, or the rating structures and methodologies, do they take into account sufficiently the differences in the underlying assets, which the differential in volatility suggests? I would say not.
Click here for Part four of the Roundtable.