Cutting the ratings agencies the tiniest bit of slack
After polluting the global financial system with hundreds of billions of dollars of overrated mortgage-backed securities and helping bring down the world economy, the credit rating agencies have been struggling mightily to repair their reputations. It’s been an uphill climb, and they were dealt another blow on Friday when a Bloomberg piece detailed academic research showing how fees influenced the assignment of higher ratings. Municipal issuers got the harshest ratings because they paid the lowest fees, according to the article.
Although higher fees definitely played a part in inflated ratings, I think there are a lot more powerful market forces at work than the study and article suggest. The academic study that the Bloomberg piece highlighted — Jess Cornaggia, Kimberly Cornaggia and John Hund’s “Credit ratings across asset classes: A ≡ A?” — focused on 30 years of data from one rating agency, Moody’s. From that data, the authors extrapolated the results to all the major raters. Here’s what Bloomberg had to say:
While the study was based on Moody’s data, it would find about identical results with data from S&P and Fitch because each firm’s grades closely track each other, Cornaggia said in an Oct. 14 e-mail.
If you work around credit markets you realize that although raters can track each other, there are often “split ratings,” or situations where the raters assign different levels to the same security or issuer. Another difference between the raters is that some move faster than others to downgrade. Fitch is typically known as the most aggressive rater in downgrading.
Practically every law and regulation that references credit ratings has a requirement for two ratings. If every rater were identical to the others, it would be redundant for laws to require two. The need for two ratings reflects the undesirability of relying on only one agency.
But put that all to the side for now. The biggest miss in the Corneggia study and the Bloomberg article is the behavior of issuers who “rating shop” and push the different agencies to inflate ratings. The Corneggia study essentially lays all the blame on the agencies for ratings inflation, but I’d suggest that the behavior of sophisticated issuers contributes a lot to the problem, too. Here’s what Columbia Law professor John Coffee told the Senate Banking Committee in September 2007:
An important dimension of “rating shopping” is the ease with which issuers can move their ratings business from NRSRO to NRSRO. They are not required to report publicly which NRSRO [credit rating agency] they are compensating for ratings or whether they have requested that an NRSRO withdraw ratings. In contrast, firing an auditor is difficult because SEC rules require full disclosure of the circumstances surrounding the termination and permit the auditor to comment.
Also, when the auditor is fired, there is great uncertainty about what the incoming auditor will do; perhaps, it will be even tougher, and certainly, it has leverage over the client. Precisely because issuers usually hire multiple rating agencies, they can drop one with less visibility or adverse consequences. In any event, the evidence clearly shows that there is a market penalty for downgrading one’s ratings.
Moody’s has reported that since it downgraded a series of structured finance offerings in July, 2007, its market share in the relevant market for mortgage-backed securitizations has dropped from 75% to 25%. In short, business in the market for ratings is mobile, retaliation is relatively costless, and hence the gatekeeper can become compromised, particularly with regard to structured finance products.
Professor Coffee’s testimony makes it clear why the Corneggia study’s reliance on data from one credit rating agency is insufficient to determine the dynamics of the entire market. There is actually a much better dataset that the Corneggia study could use to map ratings-shopping: the historical ratings data which, via an SEC mandate, are in the public domain in standardized, computer-readable format. I wrote about this in July:
We do actually have a way to watch the watchmen. We have a way to judge, over time, if rating agencies are just slapping AAA on any weak, mashed-up structured product or over-leveraged financial issuer. It’s not well known, but in June 2007 the Securities and Exchange Commission issued new rules requiring credit-rating agencies to make all their ratings available on their websites. This includes any “rating actions” that have been outstanding for more than 12 months if the issuer paid for the rating and for more than 24 months if investors paid for a rating. These ratings must be made available in a computer readable format called XBRL, a computer language that the SEC makes corporate issuers use to file their public disclosures like annual reports and 8-Ks.
When the study was published in August, I wrote to Jess Cornaggia about using this mandated SEC data to do more robust analysis. Professor Cornaggia said the SEC disclosure requirement was interesting but thought that raters might bury poor ratings in the “defaulted” category. Actually the SEC had a pretty good handle on these issues when they wrote the rules which are intentionally tight.
The SEC requirement that raters expose this historical data is for academics and others to compare ratings performance across agencies. In 2009, European regulators adopted a similar approach and are building a Central Repository to house the public ratings data. The SEC has comparable plans to build a central data portal on their website, though I haven’t heard any recent updates on that project.
Regulators have been struggling since 2005 to balance the rules and incentives for credit rating agencies. Credit markets are enormous pools with many cross currents. Finger-wagging at the raters without looking at issuer behavior is getting kind of old. It’s really time for more data-driven analysis of the raters’ performance.
Congressional Whitepaper: Creating transparency and competition in the credit markets
Bloomberg: Moody’s Municipal Ratings Obscure Bond Safety, Citigroup Says