Analysis: Turner’s proposals on rating agencies

The Turner Review, released on Wednesday, suggested regulating credit rating agencies to prevent conflicts of interest and inappropriate ratings.

Industry commentators have argued for some time that relationships between providers and the rating agencies have become too close; at its peak, about 40% of Moody’s revenues could be attributed to structured product groups.

In his review of the events that led to the financial crisis, Lord Turner says that while there is still a place for credit rating agencies, the credit market collapse demonstrated that methodologies need to be reviewed.

“Until recently… credit rating appeared to be reasonably effective, with ratings providing fairly good prediction of the relative credit risk of different bonds. As a result it seemed sensible for many institutions to embed ratings based rules in operating procedures e.g. for a corporate treasury department or charity finance function to be restricted to making deposits only with banks ranked above a certain rating, or for an insurance company or pension fund to aim for a portfolio of bonds meeting the requirements of a defined ratings based mandate.”

But Roger Doig, a credit analyst at Schroders, says that groups have put products together to make sure they meet certain criteria and receive a higher rating.

“Methodologies are made completely transparent to banks so they can be arbitraged. This is a criticism that is well-known, and Lord Turner did not add much to that discussion. But we as investors are concerned that regulators themselves have gone down the route of embedding rating agency opinions into their own regulation.”

An example is the Bank of England buying corporate bonds that are only rated as triple-B or higher, he says.

“Rating agency opinions are embedded within the psyche of the regulator. This gives power to the agencies that is probably unjustified.”

Whilst Doig acknowledges that credit rating agencies have a difficult task, “using backward-looking data to give forward-looking opinions… is inherently flawed.”

Flaws in this method of rating credit were demonstrated by the near-demise of AIG, one of America’s largest insurance firms, last year – an event Turner refers to in his review.

“The role of securitised credit increased hugely in total importance with the development of structured credit. As a result so too did the dangers that hard-wired pro-cyclicality would contribute to a self-reinforcing downturn,” said Turner.

“The growth of the credit derivatives market, for instance, created the possibility that the use of credit ratings in counterparty collateral arrangements would produce a strongly pro-cyclical effect: this danger crystallised in the case of AIG in September 2008, where a threatened rating agency downgrade led to severe liquidity strain. And as a greater proportion of securitised credit was held not by end investors intending to hold to maturity … some of these investors seem to have assumed, quite wrongly, that a rating carried an inference for liquidity and market price stability, rather than solely for credit risk.”

Peter Harvey, the manager of the Cazenove Strategic Bond fund, does not use credit ratings in his bond research. He says that agencies made the mistake of trying to “rubber stamp” structured products and collateralised debt obligations (CDOs) in the same way they do with corporate bonds.

“Credit rating agencies do a good job of rubber stamping corporate credit quality based on what you can see and touch now. They take a snapshot of the finances and business profile and rate it based on hard evidence. But this is an intangible estimate of future corporate performance.

“The main thing they have not been good at is CDOs and structured products, where they have completely failed. They weren’t conservative enough in their assumptions.”

He adds that in a corporate rating, one expects the company to maintain their rating for three years, but given the underlying volatility of structured products, their vulnerability can change within a week.

Instead of regulation, Harvey suggests rating agencies should split off the structured product business and run these entirely separately under a different name, as ratings on the products are “in danger of polluting the good work that is done on the corporate side”.

He also warns that banks and insurance companies should not be completely reliant on ratings.


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