What If We Stop Believing the Ratings?

That’s the question raised by the Financial Times’ capital markets editor Gillian Tett in a short update on rating agencies, and it’s an important one.

As we discussed earlier, the credit markets have come to depend on rating agencies:

If a terrorist were to blow up Moodys, S&P, and Fitch, it would have a devastating impact on the financial markets. Rating agencies play a indispensable role in the debt arena. Many investors are required to consider bond ratings in their investment decision making process. Insurance companies, for example, are required to hold either all or a high proportion of their bond portfolio in “investment grade” securities, which means rated BBB or better. Similarly, credit risk is one of the key issues in bond pricing, and most investors look at the agencies’ ratings as a place to start.

The rating agencies may be doing themselves in, not by anything so dramatic as a bomb, but by letting their customers lead them into areas that are beyond their skill…

Consider where we are. The rating agencies’ currency, their reputation, is on the same trajectory as CDO prices, that is, deteriorating rapidly.

Investors had carried CDOs on their books at more that they were probably worth, at first out of ignorance, because they didn’t realize the subprime paper they held was weaker than it had been historically, and later out of convenience (why recognize losses if you don’t have to and no one else seems to be doing so either?). But now the Bear Stearns hedge fund meltdown has exposed the weak market price of at least a few subprime-related issues, and investors are finding it hard to justify maintaining the old values in their books.

So to with the rating agencies that have gotten so deeply involved in structured products. It was a similar combination of ignorance and convenience that enabled the industry to ignore the deterioration of the value of a rating agency’s opinion until the Bear Stearns events made it all too apparent. The rating agencies’ propensity to downgrade well after the markets had repriced a credit was well established; their considerable conflicts of interest in rating asset backed securities were well known (how can you possibly rate what you have helped design, especially if your clients are paying you to create AAA paper?). Yet discussion of these behaviors was, just a month ago, mere background noise; now they have even garnered a comment from Paul Krugman in an op-ed piece in the New York Times, “Just Say AAA“:

The details of C.D.O.’s are complicated, but basically they’re supposed to transfer most of the risk of bad loans to a small group of sophisticated investors, who are compensated for that risk with a high rate of return, while leaving other investors with a “synthetic” asset that is, well, safe as houses.

S.& P., Moody’s and Fitch, the bond-rating agencies, have gone along with the premise, telling investors that the synthetic assets created by C.D.O.’s are equivalent to high-quality corporate bonds….

But the securities were never as safe as advertised, because the risk transfer wasn’t anywhere near big enough…

Now, you might have thought that S.& P. and Moody’s, which gave Thailand an investment-grade rating until five months after the start of the Asian financial crisis, and gave Enron an investment-grade rating until days before it went bankrupt, would by now have learned to be a bit suspicious…..But apparently not.

Now the problem with the rating agencies is that, no matter how bad a job they do, we are stuck with them. The barriers to entry are reasonably high and the profits aren’t, so there isn’t much in the way of prospective new entrants (yes, there are some small fry, but no one who could step in the breach if one of the big players were to go kaboom). And they operate with a peculiar de facto exemption from liability: they claim that all they are offering is editorial opinion, so they enjoy First Amendment protection. No kidding. And the courts have upheld it (see here, pages 12-17, for details).

So the worst that is going to happen to the agencies is that they will get called bad names in the press and have to explain themselves before Congress. But as Tett points out, their loss of stature will have real world implications:

In recent years, the credit rating agencies have been akin to the high priests of global finance, able to make or break debt products with their lofty judgments.

Now, some bankers suspect that this halo could be slipping. Late last week, JPMorgan issued an equity research report on Moody’s, the mighty US ratings agency, which downgraded the agency’s stock from “overweight” to “neutral”.

The reason? JPMorgan fears that the current jittery mood in the credit market will curb debt market activity in the coming months and thus reduce demand for ratings (a prediction that seems reasonable given what is happening to some leveraged debt deals this week).

But the US investment bank is also nervous about the risk of a future regulatory clampdown. “Should credit markets deteriorate materially, rating agencies would likely face heightened scrutiny,” JPMorgan analysts say.

To be fair to Moody’s – and its largest rating agency rivals Standard & Poor’s and Fitch – JPMorgan does not expect to see a regulatory crunch quite yet. Moreover, nobody is predicting armageddon: Moody’s margins and volumes remain high. Thus, while its shareprice has tumbled more than 9 per cent since the start of this year, it remains 16 per cent up, year on year.

JPMorgan’s action is a bellwether for the wider market nonetheless. After all, if investors and policy makers do start seriously scrutinising the agencies, they may lose faith in some of their ratings as well. Hints of heresy are already afoot: Bill Gross of Pimco said last week that many complex products do not deserve their current AAA rating – meaning they are overpriced.

If such criticism spreads – and it remains an “if” – it could undermine the price of many structured debt instruments, which could hurt mainstream credit markets further down the line. That is one more reason investors to feel wary.

In fairness, there was already skepticism of rating agency grades, but it was limited to the cognoscenti. AAA-rated securities that trade at markedly higher yields than corporate AAA bonds are the financial markets equivalent of a free lunch. And while there may upon occasion be a market inefficiency such that you will find that free lunch, I guarantee you it will never occur in the broad light of day, which is where AAA-rated instruments live. That pricing discrepancy is sending a crystal-clear message: a lot of people don’t believe that AAA is worth the paper it is written on. But clearly, some other investors decided to listen to greed, or their salesman, rather than common sense.

But now those fund manager saps who trusted the rating agencies blindly are getting embarrassed and having to explain themselves to their clients and their investment committees. They are going to regard those ratings with more skepticism.

In good old fashioned securities, like corporate bonds, the ratings methodology is well established and important data (terms of the security, performance data about the asset, informed views as to likely future performance and market prices) are all readily available, so those ratings will continue to play their historical role.

But in the structured credits market, where the rating agencies role is more important and the data and models needed for independent verification harder and more costly to come by, the downgrading of the value of the rating is likely to damage the price of the paper, at least until investors become more self-reliant.

And structured credits have become central to the extension of bank credit. Modern banks for the most part package and move credit off their balance sheets, to free up capital to make new loans. Those assets go into asset backed securities, historically relatively simple ones like mortgage pass throughs, but structured credits, which offer tranches of varying credit quality, have become far more popular. CDOs, their most advanced form, saw an estimated $1 trillion in new issues in 2006.

Doubts about CDOs and the value of ratings of complex securities generally will lead to less capital going to these products. Less demand means lower prices. Lower prices means higher yields. Higher yields means higher borrowing costs. Higher borrowing costs will further weaken the housing market and place a damper on growth.

In an excellent Hudson Institute paper, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” Joseph Mason and Joshua Rosner spelled out the implications:

In summary, the structural changes in mortgage origination and servicing have interacted with complex RMBS and highly volatile CDO funding structures to place the U.S. housing market at risk. Equally as important, however, is that housing market weaknesses feed back through financial markets to further weaken financial instruments backing today’s CDOs. Decreased housing starts that will result from lower liquidity in the MBS sector will further weaken credit spreads and depress CDO and MBS issuance. This feedback mechanism can create imbalances in the U.S. economy that, if left unchecked, could lead to prolonged domestic economic implications for U.S. standing in the world economic order.