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Sub-prime to the ridiculous

Well, at least nobody can complain about another dull summer in the financial
markets. When Federal Reserve chairman Ben Bernanke warned that losses from the
sub-prime meltdown could reach $50bn, bankers, mortgage lenders and hedge fund
managers across the globe manned the panic stations. Central banks in the US,
Europe and Japan sprung into action, injecting more than $240bn into the system
in a frantic effort to bail out investors and contain the shock waves.

For many, it was too late: the list of casualties to date includes top
international bank executives and a host of funds that had invested in the
collateralised debt obligations (CDO) that lay at the heart of the crisis – “a
toxic time-bomb”, as one market watcher described these highly complex financial
instruments that so cleverly disguised the rot within.

Early casualties
As early as June, Merrill Lynch had seized $800m in assets from two Bear Stearns
hedge funds that were involved in securities backed by sub-prime loans.

In August, American Home Mortgage Investment Corporation had filed for
Chapter 11 bankruptcy and French bank BNP Paribas stopped valuing three of its
funds and suspended all withdrawals by investors after sub-prime mortgage woes
had caused “a complete evaporation of liquidity”.

Goldman Sachs’ $8bn Global Alpha hedge fund reportedly lost 26%, while
Citigroup took $700m in losses in its credit business.

Countrywide Financial, the largest US mortgage lender, saw its shares fall
13%, its largest one-day decline since the 1987 stock market crash, on fears
that the company could face bankruptcy. Rams Home Loans Group, an Australian
lender, announced in August that the company was unable to refinance short-term
debt as buyers stayed away from the credit markets. Rams shares fell as much as
41% on the Australian Stock Exchange. In Britain, the sub-prime crisis has
pushed mortgage lending rates to their highest level in nearly a decade.

All this has prompted US treasury secretary Hank Paulson to warn that the
crisis of confidence is likely to last longer than the financial shocks of the
past two decades. It looked like the markets might be heading for a global
recession, and so far there’s no light at the end of the tunnel.

It wasn’t long before unhappy investors began casting about for scapegoats
and one of the leading suspects turned out to be the credit rating agencies. The
structured instruments behind the sub-prime mortgages that were bundled into
securitised assets and sold to investors attracted top AAA ratings from the
three agencies that exercise a virtual oligopoly in the credit rating business –
Fitch Ratings, Standard & Poor’s (S&P) and Moody’s.

But it’s not just those investors who lost their shirts that are pointing the
finger – at last count, half a dozen US states were jointly investigating the
rating agencies that benefited from the boom in sub-prime mortgages. The
questions being asked are whether the agencies acted irresponsibly in assigning
their top ratings to these securities, whether they failed to act quickly enough
to warn investors about the risks and if there is a compelling argument for
placing them under regulatory control.

Poor ratings
There is already ample evidence that credit rating agencies often do not
downgrade companies promptly enough. Enron’s rating remained at investment grade
four days before the company went bankrupt, despite the fact that credit rating
agencies had been aware of the company’s problems for months.

“Today, it is clear that the agencies have an easier time rating a corporate
than a financial institution,” says Tony Lomas, a partner at
PricewaterhouseCoopers. “You can have a conversation with the corporate’s
treasurer or finance director and get an understanding of the derivatives that
might be there and come to an informed view about the company and its
creditworthiness. When you’re trying to do that with a large financial
institution, it’s extraordinarily difficult. On that level, you’ve got to
sympathise with the agencies as there is only so much information available to

When an agency is trying to rate structured finance, it comes across a huge
amount of interdependency around rating actions. A structured finance vehicle’s
rating is built on the ratings of myriad other securities. Trying to predict the
cascade effect of a particular rating action and understand how that will flow
through is a mind-blowing task, which is why it’s so important to get it right.

As for the current crisis, the sharp rise in foreclosures in the US sub-prime
mortgage market was a well-known fact in 2006, yet these securities continued to
attract AAA ratings. Large corporate rating agencies have been criticised for
having too familiar a relationship with company management, possibly opening
themselves to undue influence or the vulnerability of being misled.

The US Securities and Exchange Commission (SEC) has been looking into the
behaviour of these agencies since the advent of Sarbanes-Oxley, while two years
later the International Organisation of Securities Commissions published a code
of conduct that, among other things, is designed to address the types of
conflicts of interest they face. Charlie McCreevy, the EU Internal Market
Commissioner, has told the agencies that they must improve their performance and
dispel the cloud of doubt that hangs over their quality of judgement and level
of transparency.

On the conflict of interest question, companies pay hefty fees for a rating
that provides reassurance for lender banks. A high rating also enables
corporates to make an optimum return on the securities they issue to raise
capital. The agencies’ power is enhanced further by Basel II, under which
regulators allow banks to use credit rating agencies to calculate their net
capital reserve requirements and assess their risk.

Negligence claims
The agencies dismiss all charges of negligence and insist that their ratings are
nothing more than opinions.

The agencies are understandably eager to protect their fiefdom, a highly
lucrative business that has enabled Moody’s, for instance, to more than double
its net income to $754m in the past five years. The agencies point out that
ratings are not designed to reflect an outlook for the market price of a debt
instrument, only the likelihood of default and possibly the potential losses
involved. Yet, when Kathleen Corbet, president of S&P, fell on her sword in
the wake of the sub-prime debacle, critics could not help but consider their
suspicions confirmed.

S&P still disputes the accusations, as does Moody’s, which maintains that
it does not design, structure or price securities, but only offers a
forward-looking opinion.

Fitch Ratings recently published a report explaining its view of what credit
ratings mean. “Fitch’s credit ratings provide an opinion on the relative ability
of an entity or transaction to meet financial commitments such as interest
payments, repayment of principal, insurance claims or counterparty obligations,”
the agency says. However, 60% of Fitch’s AAA ratings are for structured finance
transactions of the type that contain sub-prime mortgage tranches.

Few investors bothered to look beyond the juicy yield on these AAA-rated
securities (if, indeed, anyone was able to understand their highly complex
structures) and the banana skins sandwiched between the tranches. It is not
entirely dissimilar to buying a second-hand car that carries a six-month
warranty. If the wheels fall off, the buyer needs to think about the salesman
who stands behind that warranty. The difference, of course, is that the car
buyer can lodge a claim over his misleading warranty. For the investor in
worthless bonds, it’s caveat emptor.

In November 2004, the Committee of European Securities Regulators released a
consultation paper considering the potential regulation of credit rating
agencies. However, all that has emerged so far is an ineffectual code of
conduct, instead of legislation to provide some redress for investors. This
would at least be a step towards returning credibility to an industry that is
rapidly losing investor trust and respect.

Corbet, former president, Standard & Poors, responds.

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