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Swing Vote full The credit rating agencies like Moody’s, S&P and Fitch have come under sharp criticism from all sections of the industry of being accused for possible conflicts of interest arising from (a) rating agencies being paid by issuers and (b) rating agencies offering advisory services to issuers. The motivation for rating agencies to act in the interest of issuers originates from institutional arrangements, whereby issuers pay for issuer-level and bond-level ratings, and also choose which rating agency (possibly more than one) will produce the rating. Almost all rating agency revenues are from ratings fees. Rating agencies also offer fee-based ancillary consulting type services to issuers, which may exacerbate conflicts of interest. For example, prior to being issued a public rating, issuers can purchase an “indicative” or private rating, along with “advice” regarding how the company might improve their rating. Clearly, one mechanism for acting in the interest of issuers is to delay rating downgrades.

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Delaying the negative news in downgrades may benefit issuers in a number of ways. It postpones the associated increase in funding costs. But the benefits may extend well beyond the costs of borrowing, since a downgrade could trigger certain covenants or other conditional obligations. The issue of the conflict of interest among the credit rating agency is not a recent one. This issue has been raised more than one occasion and a lot of literature is available on it. The rating agencies came under fire even when the Asian Crisis broke in 1997. At the onset of the crisis, investors accused these agencies of not warning them of the troubles ahead. Asian companies and governments blamed them for fuelling the crisis with frequent and often sharp downgrades of sovereign and corporate debts. Similarly, there were criticisms of rating agencies, when there were delays in recognizing the credit-quality deterioration of Enron Corp, prior to its failure at the end of 2001. By waiting until Enron’s bonds had plummeted in value, the ratings agencies failed in their job of anticipating a company’s financial problems and giving investors an early warning Investor skepticism was heightened by news reports that Moody’s, S&P, and Fitch had behind-the-scenes meetings with, and had been lobbied by, executives from Enron, Dynegy, J.P. Morgan Chase, and Citigroup, and “agreed to hold off on making any ratings move,” essentially so as not to bankrupt the company.

Rating agencies claimed their decision to hold-off on the downgrade was justified, given their belief, at the time, that a pending merger was likely to protect bondholders. The Securities and Exchange Commission issued a report in July, 2008 saying that the three major credit rating agencies have significant deficiencies in policies and procedures for rating structured products tied to subprime mortgages — including conflict-of-interest problems with their “issuers pay” fee model. The report culminates a 10-month SEC examination of the three top credit rating agencies — Standard and Poor’s, Moody’s Investors Service, and Fitch Ratings.

The SEC report was a shocking insight into this most important but opaque part of the global finance machine. The report cited e-mails suggesting that the raters knew that collateralized debt obligations were headed for problems. One e-mail from an agency analyst said that her firm’s ratings model did not capture “half” of one deal’s risk, but that “it could be structured by cows and we would rate it.” In another exchange, an analytical manager in one agency’s real estate group wrote that, “staffing issues, of course, make it difficult to deliver the value that justifies our fees.” In another e-mail, a ratings agency manager called the CDO market a “monster” and said: “Let’s hope we are all wealthy and retired by the time this house of cards falters.” The Chairman of SEC asserted that more evidence would be needed to connect any one E-mail or instant message to specific problems, but said the “take away” from the report is that credit agency employees revealed a “generalized concerns about laxity and stated norms” in their exchanges.

These ratings were supposed to be independent verification of the level of underlying risk. So when the agencies were extremely generous in giving out the highest AAA ratings like, many investors were reassured that the risk they were taking was suitably low. Now it is clear that the ratings agencies hadn’t a clue how to measure the real underlying risk in these complex investment vehicles. As the SEC reveals, they often lacked the expertise to analyze these securities, and ‘When the firms didn’t have enough staff to do the job right, they often cut corners.’ In fact, it can be reasonably argued that in many cases they had absolutely no incentive to uncover the real level of risk, as they relied for their income on the fees paid by the companies creating these securities. To blow the whistle would have meant an end to the steady and lucrative stream of business still coming in. The boom in structured finance – best described as the repackaging, restructuring and resale of existing debts – placed the ratings agencies in a qualitatively different role.

Instead of rating already extant bond issues, they became intimately involved in the issuance process itself, advising the investment bankers and their clients on how to obtain the necessary ratings for their new loans. The structured finance bond issuance production line offered fat fees to bond underwriters (the investment banks) and to the rating agencies. Moody’s alone earned nearly US$1 billion a year from rating structured finance issues in 2005 and 2006, overshadowing revenues from the more traditional activity of rating government, municipal and corporate bonds. For example, ABN Amro issued a few securities, which Moody’s rated triple-A. But when Moody’s went back to double-check its calculations, it found a bug in the computer code used to generate that rating.

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When the bug was fixed, it turned out that the securities in question should have been rated four notches lower (Jones et al, 2008). But Moody’s never rerated the securities in question, and indeed it continued to give triple-A ratings to new, almost identical, securities. It did this because it was making a lot of money by rating them because by sheerest coincidence, at exactly the same time as it fixed that computer code bug, Moody’s also made two changes to its ratings methodology elsewhere - changes which resulted in this class of securities retaining their triple-A rating.

So to conclude, credit rating agencies have significantly contributed towards the current economic downturn and one of the key ways to address this will be for government and regulatory bodies to institutionalise and make the process of rating more transparent to external world.