The demands of winning and retaining clients in the more lucrative consultancy business came to threaten the integrity of audit work. It was a conflict that helped bring down Arthur Andersen following the collapse of Enron, the Texas-based energy trader whose books the accounting firm had audited. “I do hope that it does not take another Enron for everyone to look at the issue of rating agencies,” Mr Prada told the Financial Times in March 2007.
The global credit collapse has since prompted regulators around the world to shine an increasingly harsh light on ratings agency practice. A damning report this month from the US Securities and Exchange Commission uncovered “serious shortcomings” in the rating of securities related to subprime mortgages, the products that triggered the crisis. Such findings have cranked up the regulatory pressure on both sides of the Atlantic and the ratings agencies face a very uncertain future.
Regulators are also focused on the industry because of the dominance that the three leading operators enjoy. They act as financial market gatekeepers by deciding on the riskiness of various kinds of debt. In addition, the judgments of the big three – Standard & Poor’s, Moody’s Investors Service and Fitch Ratings – have become “hard-wired” into the global financial system, through the inclusion of their ratings as standards in investment mandates and banking rules, for example.
Like auditors, the business of agencies is to give their opinion – and so the credit ratings they award are only as good as the integrity and procedures of the agencies themselves. The credit crisis soon brought protests that they had failed to warn investors early enough about the risks of complex securities.
Confidence in the three main agencies – which are paid not by investors but by the sellers of securities, such as big Wall Street banks – has been dented before. In the wake of Enron, the agencies had to defend lawsuits brought by debt investors who claimed the agencies that rated the company’s debt did not do enough to spot Enron’s increasingly dubious financial condition. Using a first-amendment defence under the US constitution, the groups successfully argued that grades handed out on debt were merely an opinion. Thus they could not be blamed if that turned out to be based on false information provided by a client.
But recent events have thrown the systems, processes, resources and – most of all – the integrity of the agencies into sharp relief. The SEC’s report into the three main agencies was the result of a 10-month review in which more than 2m e-mails and instant messages, as well as other documents including deal files, were examined. Christopher Cox, the SEC chairman, said: “We’ve uncovered serious shortcomings at these firms, including a lack of disclosure to investors and the public, a lack of policies and procedures to manage the rating process and insufficient attention to conflicts of interest.”
Although the SEC, which gained authority over the ratings business only last September, did not link specific agencies to any of the findings, it gave examples of behaviour found at one or more of them. “At one firm, internal communications appear to expose analytical staff to [a] conflict of interest by indicating concern or interest in market share when employees were discussing whether to make certain changes in ratings methodology,” the report said. While each agency had policies and procedures restricting analysts from participating in fee discussions with issuers, it added, these policies still allowed key participants in the ratings process to participate in discussions about fees.
“When the firms didn’t have enough staff to do the job right, they often cut corners,” said Mr Cox. The review also found weaknesses in documentation and internal audit processes.
Also, in a worrying echo of the practices of some dotcom-era investment bankers and analysts, agency employees also cast doubt on the quality of some ratings given to products such as collaterised debt obligations (CDOs). One credit rating analyst said in an e-mail that she believed her employer’s model did not capture even half of the risk inherent in a deal – but that it “could be structured by cows and we would rate it”. Another e-mail from one analytical manager to a senior manager said the ratings agencies “continue to create an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”
The SEC report came just days after Moody’s announced disciplinary proceedings against some of its staff and admitted it had incorrectly rated about $1bn (£501m, €631m) in complex debt securities due to a computer error, as revealed in an investigation by the FT (see below). The SEC’s own inquiry into the issue continues. Meanwhile, S&P recently told regulators it had found an error in the computer models underpinning the credit ratings of complex debt products but that the glitch did not affect the ratings given to the debt.
At least in part, the revelations reflect growing stresses at the ratings agencies as the market for complex debt securities boomed. The rapid increase in workload stemming from the increased number and complexity of subprime-related securities put burdens on employees quickly to analyse ever more sophisticated products. As a result, analysts sometimes deviated from their own models and procedures, the SEC found.
Indeed, at the heart of these problems has been the explosion in complex debt products this decade, which in turn fuelled a massive expansion in risky mortgage lending by appearing to chop and disperse that risk among investors around the world. S&P, Moody’s and Fitch have been crucial to the credit bubble by giving their stamps of approval to the alchemy of securitisation, the financial technology used to turn difficult-to-sell individual loans or bonds into tradeable securities.
That repackaging allowed top-class triple-A ratings to be awarded to bonds made up of risky mortgages, or even of risky slices of other bonds backed by those mortgages. Without the agencies’ ratings, many investors would never have bought these bonds in the first place. But all the big three argue that their ratings are meant only as a starting point for due diligence by professional investors. They maintain – as they did after the failure of Enron – that they cannot help that their original opinion turned out to be wrong or based on false information from clients. All they can do is monitor the performance of rated debt and keep investors updated when that performance makes downgrades necessary.
In the case of the mistaken ratings for the products involved in the recent Financial Times investigation, Moody’s stressed that there was no evidence that its staff had deliberately manipulated the overall ratings methodology to conceal the bug. But it conceded that “some committee members considered factors inappropriate to the rating process” when looking at the products. Raymond McDaniel, chairman and chief executive, said: “The integrity of our rating process is core to Moody’s values and is essential to the market.”
According to one investor in Moody’s shares, this integrity is vital. “I think people understand that making mistakes is one thing and that Moody’s can’t be sued for a wrong rating,” the investor says. “But if someone can prove either malfeasance or reckless disregard, that is a different story.”
Deliberate wrongdoing, malfeasance or reckless disregard is far from proved for any of the agencies. In addition, after co-operating with the SEC examination, each of the agencies has agreed to take “remedial actions”, according to Mr Cox.
But a wider rethink is also under way. Groups such as the Basel Committee for Banking Supervision and regulators including the New York Federal Reserve are also looking hard at whether they can reduce their own dependence on ratings. The SEC, for instance, wants to strip references to ratings in rules so that money market funds and other investors can make greater use of their own discretion.
Yet reducing the degree of “hard-wiring” in the system would be difficult to achieve quickly. Thus one big regulatory focus is on changes to restore confidence in the agencies. In both the US and Europe, conflicts of interest, a muddier but more palatable idea for all involved than outright dishonesty, are being aired as a central concern, as is the ability of the industry to regulate and monitor itself.
In the US, concerns about conflicts of interest and oversight that were levelled at auditors in the wake of Enron’s collapse led to the forced separation of audit from other services including consulting and tax work. It also brought the creation of an independent Public Company Accounting Oversight Board, designed to supervise a self-regulatory system for auditors.
Ratings agencies insist there is no parallel and that, for instance, they do not perform consulting work of any kind when it comes to rating new products. But the SEC has proposed new rules to govern the industry, such as prohibiting an analyst who has helped structure a product from giving it a rating, or banning analysts who give ratings from participating in fee discussions. “These examinations clearly indicate that more needs to be done at credit ratings agencies to ensure that investors can have confidence in this system of ratings,” said Mr Cox.
In the European Union, where the agencies are not yet subject to oversight, Charlie McCreevy, financial and markets commissioner, has called for a system that would force policymakers to scrutinise the agencies’ business models and practices. Last week, the 27 finance ministers from EU member states endorsed that view. Mr McCreevy says the recently beefed-up code of conduct for agencies from the International Organisation of Securities Commissions, a grouping of regulators, is “toothless”, in part because it is voluntary. Christine Lagarde, finance minister of France, which currently holds the EU presidency, says: “We reached agreement on the principle of registration of ratings agencies and, second, on the need to monitor ratings agencies.”
Yet while European agreement on a principle may be simple, establishing how any direct monitoring or oversight will work is far more difficult. For a start, regulators do not have the staff to check all the models that ratings agencies use.
For the agencies, one of the biggest problems is the prospect of dealing with regulatory demands on at least two fronts. “It’s important that any new external oversight of rating agencies follows a globally co-ordinated approach in order to ensure consistency for investors and issuers operating in international markets,” says S&P. While this regulatory uncertainty prevails, the collapse of structured product business in the financial markets has already cut a big chunk from the agencies’ revenues and profits. (The main three each report financial results differently but Moody’s, the only one with its own stock market listing, drew 40 per cent of its total revenues from the structured product ratings business in 2006.) They have already been cutting staff to adjust.
Unfortunately for the agencies, the big questions over their integrity come just when their business has weakened. Their ability at such a time to fight the forces of political whim and regulatory zeal on two continents is among the biggest tests the industry has faced.
How Moody’s blues began with a bug
As structured finance boomed, the inner workings of the credit rating agencies, much like those of the complex products they appraised, went unquestioned, write Sam Jones and Gillian Tett.
Ratings agencies are some of the most powerful forces in the market. A rating can make or break a deal; a downgrade can sink a bank or even bankrupt a country. Now, in the wake of an unprecedented number of downgrades and the collapse of many structured financial products, ratings agencies are coming under intense scrutiny. Questions are being asked not just about the ratings they issue but also about the management systems and computer models used to assign these ratings.
Take the case of Moody’s Investors Service. Until recently, the agency’s constant proportion debt obligation rating committee was unknown to most who work in finance, not least because CPDOs were some of the most complex products to emerge from the credit boom.
However, last month the agency admitted for the first time that the way this committee had rated a batch of CPDO products in 2006 was flawed. The committee originally issued coveted triple-A ratings to the CPDOs – leading some to label such instruments the holy grail of structured finance, since they also promised high returns.
As a Financial Times investigation this year showed, however, a computer bug in Moody’s mathematical codes had distorted the CPDO ratings by about four notches. The CPDO rating committee discovered the error in early 2007 and fixed the bug but, as a result of other changes made to the model, the products kept their triple-A ratings until early 2008.
Moody’s said following an internal investigation that, while there had been breaches of internal guidelines, there had been no attempt to cover up the error. The saga nevertheless illustrates a much bigger issue, which cuts to the heart of the problems worrying financial regulators: the degree to which ratings agencies are equipped to double-check the highly complex – and, for investors, highly significant – decisions they have had to make in recent years.
In the case of CPDOs, for example, the bug occurred at a time when the agencies were all badly stretched. Last year Paul Mazataud, a senior managing director at Moody’s, told a conference of bankers that the agency was “working night and day to rate CPDOs”. Client banks say there was a backlog of issues waiting to be rated.
The Moody’s CPDO committee was chaired by the same executives, Gareth Levington and Anne Le Henaff, who were in charge of rating CDOs – a much larger product class at the heart of the current mortgage bond crisis. Membership of the CPDO committee itself was spread around the world and ratings were discussed briefly and at short notice.
Moody’s now says disciplinary procedures have been initiated against staff on the CPDO committee, although it has not identified which committee members and would not comment on the identities of people involved in the ratings process. The action comes after Sullivan & Cromwell, a law firm hired by the agency to investigate the CPDO rating process, delivered its findings to Moody’s executives last month. Noel Kirnon, the agency’s global head of structured finance, left in the wake of the report – though Mr Kirnon was never involved in the rating of CPDOs.
The bigger question that dogs the industry is how to ensure that resources keep pace with banking innovation – as the current US regulations require.
One of the only comforts to regulators now – of a sort – is that the collapse of the structured finance market does at least mean ratings agencies are no longer overwhelmed by deals. Indeed, many are quietly redeploying specialist staff from asset-backed structured finance to healthier market areas.