IOSCO- the International Organisation of Securities Commissions - has just published its long anticipated consultation paper on the role of the rating agencies. (The paper also includes the actual new clauses to be inserted into the IOSCO code of conduct).
IOSCO is not just an international gentlemans’ club for holidaying civil servants. The technical committee, which published this report, comprises the chief executives and most senior directors of the world’s biggest financial regulators. Among them the UK’s Hector Sants.
It’s through IOSCO that any changes to regulation of rating agencies in any country will come. The FSA in particular, its understood, has been lobbying through IOSCO for sweeping changes. If you can see through the fug of diplomat speak in this latest paper - it’s clear that changes are going to be made.
What’s particularly interesting though is that IOSCO are tackling head on the rating agencies structured finance business. And of interesting legal import, this paragraph:
CRAs and their ratings played a critical role in the recent market turmoil… credit ratings have had an inordinate impact on the valuation and liquidity of subprime RMBSs and RMBS-backed CDOs. In part, this resulted because many investors and market participants effectively outsourced their own valuations and risk analyses of RMBSs and RMBS-backed CDOs to the CRAs - a tendency the CRAs, some believe, had little incentive to discourage given the growth and profitability CRAs have experienced in this market segment over the past several years. Making matters worse, there are serious questions whether these credit ratings were based on incorrect information and faulty or dated models.
The rating agencies alone, of course, aren’t to blame. But this is a strong indication of their complicity in the crisis - a position of vulnerability hitherto skirted around by regulators and rating agency officials alike.
And in particular, it’s the structured finance business that IOSCO is recommending changes to.
…ratings based on information that fails to pass even a basic -sniff test - or, more importantly, methodologies which fail to take into consideration market changes which may have an impact on the quality of the information upon which the ratings are based - fundamentally undermine investor confidence in the rating process. Consequently, investors and regulators expect CRAs to take reasonable steps to ensure that the information they use is of sufficient quality to support a credible rating.
A credit rating, then, is occasionally viewed as not only a CRA’s opinion of the loss characteristics of the security, but also as a seal of approval. This perception is not entirely without merit given that a CRA rating of a structured financial product is qualitatively different from a corporate bond rating based on an issuer’s past financial statements…
Investment banks and structured finance issuers frequently ask CRAs to provide prospective assessments on CDO tranches before deciding upon which CRA to hire, arguably engaging in -rating shopping in doing so. It is conceivable therefore, that CRA competition and the lack of transparency typical in structured finance transactions may combine to undermine the integrity of the credit rating process for these products.
All of this, is, perhaps, long overdue. Rating agencies enjoy a peculiar position in international regulation. On the one hand, Basel II, enshrines ratings within law as much more than just a rating agency’s “opinion” and through ECAI status, makes ratings essential for capital management. But on the other hand, the validity or reliability of those ratings is uncheckable or enforceable by regulators. It’s thus not always a case of investors neglecting their own due diligence and simply ‘buying the label’ but sometimes a case of them being legally required to do it. As IOSCO states:
In many cases, this entails regulators permitting regulated entities to rely on the ratings of a security in place of the entity assessing the underlying risks of the security itself.
A General Counsel for Fitch once claimed that ratings were “the world’s shortest editorial”. IOSCO’s report goes some way to countering that principal. Journalistic privilege under the first amendment has, for too long say some, been a fig leaf behind which rating agencies have hidden.