The Credit Rating Agencies: How Did We Get Here?

What was the role of the credit rating agencies in the credit crisis, and how can they be cleaned up to ensure this never happens again?

We're at a point where incremental changes aren't going to be effective. We've got to make dramatic changes in the areas of transparency, how rating agencies are paid, and ensuring that absolutely no conflicts of interest exist between the part of the company that's rating and the other part that's providing consulting services. I don't think those issues have effectively been addressed yet." These were the words of Jim Kaitz, president of the Association for Financial Professionals (AFP), an invited speaker at the SEC’s Roundtable on the Credit Rating Agencies, 15 April 2009.

How did we go from a world where once a security was rated, we believed that changes to that rating, whether positive or negative, would be in an orderly and gradual manner, to an environment where a security could be given the highest credit rating, AAA/Aaa, and in a relatively short period of time, that security could be considered junk?

The Reasons

There are many authors of our current financial crisis, but the major credit rating agencies (CRAs), Fitch Ratings, Moody’s and Standard & Poor’s played a special role and bear a special responsibility. Whether the CRAs wish to admit to it or not, how and what they rate securities has a significant impact on investors of all stripes. I find it very interesting that we live in a world where practically no professional investor or corporation is permitted to buy unrated securities, but when there is a problem with a rating, the response from the CRAs is caveat emptor (let the buyer beware).

The CRAs get paid to analyse countries, companies, governments and structured securities. Since they are getting paid to do this work, I’ll assume there is value added. At the very least, this analysis should be basically and fundamentally correct.

At the crux of our current situation is a horrible assumption - the price of housing in the US never goes down (as a national average). The problem with an average is that it is an average. My point is that you can have one foot in a pail of ice water and one foot in a pail of boiling water and on average the water temperature is comfortable, but that is hardly the case.

It is true that in the US, on a nominal basis, the average price of the national housing stock from roughly the end of World War II until 2005 had never decreased on a year-over-year basis. However, when the effects of inflation are factored out, not only do we see that in some years housing prices actually dropped, we also see the average yearly rate of appreciation over that period of time was only about 2% per annum.

The reason I share this history lesson is that I’m not a professional credit analyst working for one of the CRAs. I’m just a finance professional who has been around the housing and mortgage market for more than 20 years.

Beginning in the earlier part of this decade, we saw several very interesting phenomena occur:

My question is, how could you have had so much new product being created and the CRAs not see any additional risk? OK, to be fair to the CRAs, they did see risk in these new untested structures, but no more risk than the US defaulting on its debt. (And the government owns the printing press so, in theory, you will always be paid back on government securities, but the dollars may not be worth anything.)

Again my concern is that the CRAs saw an asset class appreciating at a historically unsustainable rate, loans being made with very lax terms in both credit underwriting as well as repayment requirements, and the ownership of the risk moving dramatically away from the originators and the structurers.

The reaction from the CRAs was that, if you structure a risky asset class ‘properly’, you can create a ‘safer’ asset. I’m not going to argue there isn’t value in securitisation, but you have to understand what you are securitising. If you derive value from being a secured lender, and the value of your collateral goes to zero, it doesn’t matter how much collateral you have, you are now an unsecured lender.

Basically, the CRAs did not properly evaluate the risk characteristics of all of the low-doc, no-doc, option ARM, low-down payment, no-down payment, negative amortisation, interest-only, sub-prime, and Alt-A mortgage products that were created.

I don’t think there is much of an argument there. So, now the question is why the CRAs rated these products as high as they did. I don’t believe the CRAs intentionally set out to be wrong or to hurt investors. If you are a credit rating agency it is not in your best interests to be consistently wrong. Investors have a nasty habit of not utilising the services of those who don’t help them and especially of those who hurt them.

What Went Wrong?

The motivations of the CRAs got out of sync with the needs of the investors. During the boom years, the more transactions the CRAs rated, the more fees they earned. Prior to the mortgage market cracking, it was difficult to argue against all these new esoteric products coming into the market, where if you didn’t rate the product high enough, the security couldn’t be created.

We entered into a world where reasonable people looked at this new product and thought, “This is new and untested, and nothing has gone wrong yet. If I don’t rate this product high enough, the deal doesn’t get done and we don’t collect our fees. Who am I to rock the boat?”

Avoiding Making the Same Mistakes

So how do we prevent this situation from occurring again when the next great investment structure comes down the pike? To paraphrase the comments from AFP’s Kaitz, we've got to make dramatic changes in how rating agencies are paid and also really make sure that absolutely no conflicts of interest exist.

The days of trying to minimise the conflicts of interest are over; we need to eliminate the conflicts of interest. We need to develop a new business model of how CRAs are paid. We must eliminate the straight line between producing high ratings and compensation.

Whether we develop some type of a utility model, where the compensation is derived from a transaction fee, the important element will be the separation between the analysis and the compensation.

Article by Brian Kalish. He has responsibility for the finance practice which includes corporate finance, risk management, capital markets, accounting and financial reporting. Kalish has over 20 years experience in finance, treasury and investor relations.