Reputations on the line for ratings agencies

Having failed to call the credit crisis, the rating sector's image needs a makeover. By Stephen Foley

Warning: may contain nuts. The credit-rating agencies, fingered early on as important villains in the unfolding credit crisis, have alighted on a new plan to shore up investors' confidence in their abilities and to head off potentially ruinous new rules from angry law-makers. They suggest putting a warning label on many of their credit ratings, alerting investors to the limitations of their research and the possibility that they may be wrong.

At this stage, that might look like a statement of the obvious. As Wall Street churned out more and more exotic financial instruments in recent years, agencies led by Standard & Poor's and Moody's stamped many with gold-plated triple-A credit ratings, signalling to investors that they were as safe as government bonds.

Only, that turns out to have been fantasy, and shocked investors who thought they had rock-solid portfolios have found themselves sitting on giant losses. From the retirement funds of tiny local authorities in the US, to the trading desks of the titanic Wall Street banks, more than $100bn (£50bn) of value has been wiped out because of the mushrooming numbers of defaults.

So there is no longer any doubt that the agencies have been very, very wrong in assessing the creditworthiness of exotic mortgage-related bonds and other credit derivatives, particularly the parcels of debt known as collateralised debt obligations, or CDOs.

Fitch – No 3 in the triumvirate of major rating agencies – admitted as much yesterday. It said it was introducing a "new methodology" for predicting the likelihood of a default by CDOs that contain parcels of corporate debt. The change of view could result in downgrades to every single one of the $220bn worth of CDOs that it rates. That comes on top of the $67bn of mortgage-related CDOs that it downgraded in November, when many triple-A rated bonds were cut in a single move down to junk status.

The idea of public health warnings on credit ratings was proposed this week by Moody's, part of a discussion paper that also suggested it could abandon traditional ratings on exotic credit products all together and replace them with a different sort of scale.

"Moody's credit ratings are forward-looking opinions that address just one characteristic of fixed-income obligations – an assessment of the likelihood that such obligations will be repaid in accordance with their terms," said Andrew Kimball, chair of credit policy.

"Our role in the structured finance market is fundamentally the same as the role Moody's has played over the last hundred years in the corporate bond markets. Nonetheless, some performance characteristics of structured securities have demonstrated behaviours in certain asset classes that are different from those of corporate and governmental securities."

The specific aim of Moody's proposed reforms is to give investors more information, both about the bond they are buying and about the way the agency came up with its credit rating. Warnings could include a volatility rating, signalling how likely it was that the creditworthiness of the bond could be revised down, or even a quality indicator to reflect the quality and the complexity of the data underlying Moody's assumptions.

Of course, the proposals have a much broader aim, too – to get politicians and regulators off its back. At the height of the credit crunch last summer, both houses of Congress took up cudgels against the agencies. Executives were summoned before the Senate banking committee in September and forced to defend themselves against charges the agencies were riddled with conflicts of interests.

Two Congressional committees and several attorneys-general across the US have launched formal investigations into whether the agencies gave artificially inflated ratings in order to win business from Wall Street banks, which paid for the ratings. "It is like a movie studio paying a critic to review a movie and then using a quote from his review in the commercials," one law-maker said at the time.

This week, at a meeting in Amsterdam, the International Organisation of Securities Commissions is discussing a co-ordinated regulatory response to the rating agencies' failings, while the European Union and the US Securities and Exchange Commission are pursuing parallel inquiries.

But all the agencies have insisted on their good faith, saying overly optimistic credit ratings stemmed not from conflicts of interest, but from deteriorating lending standards and fraud by mortgage brokers.

The new mortgage-related CDOs did not behave the way the agencies' models predicted because their very existence changed the dynamics of the mortgage market, pulling in more risky borrowers than ever before and leading to an unprecedented spike in arrears. Plug in what we have learnt, and the models come up with very different credit ratings from here on in.

So far, no attorney general has turned up a scandal, and the political heat appears to have turned down, too. The agencies are using this lull to frame the debate as a technical one about how to improve their inputs, tweak their maths, and get a more accurate read-out next time round.

"Our philosophy is that we're trying to be extremely transparent. We are trying to explain to everybody exactly what our thinking processes have been," Philip McDuell, Fitch's head of structured credit for Europe and Asia said yesterday as he unveiled the agency's revised CDO methodology. "There are no black boxes here. We've opened ourselves up, and we're actively looking for feedback on it."

The outcome of these internal, regulatory and criminal reviews will have enormous consequences. Whether it be a bog-standard municipal government bond or a synthetically created parcel of derivatives and other complex financial instruments, the credit rating of a bond is vital to the price at which it trades. You need look no further than the current turmoil in the monoline insurance industry, which guarantees CDOs and municipal bonds against default, to see how important the credit rating agencies are. When one of these insurers, ACA, lost the triple-A rating on its own corporate debt, the value of its guarantees became effectively worthless and its business collapsed.

The credit rating of a bond is also vital to which investors are allowed to buy it, since many pension funds are barred by their trustees from taking on the risk of anything other than triple-A rated debt.

Whatever the outcome of all the reviews on the rating agencies, it seems there will have to be big changes too for the investors. That will be the real power of a public health warning on a credit rating; it is a reminder to investigate properly what you are buying.

"Credit rating agencies are a necessary evil," says Kevin Logan, senior US economist at Dresdner Kleinwort. "We cannot do without them, because we need these umpires to give an official view on the quality of various securities. But investors who really do their homework don't just rely on the rating agencies anyway."