Investors Weary of Rating Agencies Past and Present

MBA (8/27/2008 ) Murray, Michael
A lack of investor confidence in rating agencies is only one aspect keeping investors away from commercial and residential mortgage-backed securities, and current models could cause an even longer wait.

In their original design, ratings agencies provided research and information to debt buyers on an asset, but in 1975 the Securities and Exchange Commission named seven rating agencies as Nationally Recognized Statistical Rating Organizations. In the current model, debt issuers pay to get loans rated. Otherwise, they cannot sell them. Issuers “shop” loans to determine which ratings agency would give the debt its highest rating.

“Standard & Poor’s recognizes that the issuer-pays model we have been using for the past 30 years may raise potential conflicts of interest. What is important is how we continue to manage such potential conflict,” said Vickie Tillman, executive vice president at S&P, from an op-ed article, Credit Ratings Integrity, in April’s Washington Times. “In this regard, ratings firms are not unique. Potential conflicts of interest are common in the world of business, which is why companies in virtually every industry have stringent policies in place to manage them.”

Industry participants, investors and advisors said rating agencies need to take responsibility and admit fault in giving subprime RMBS pools investment-grade ratings.

“I’m wondering if [investor] confidence is permanently damaged; we’ll see," said Michael Shedlock, investment advisor representative at Sitka Pacific Capital Management, Edmonds, Wash. "It certainly is from my aspect. That does not mean the market will see it the same way I do.”

In testimony before the Senate Banking Committee in April, Tillman outlined 27 initiatives in four categories that S&P turned into its Leadership Actions Web site. The actions include steps to manage potential conflicts of interest, the Tillman said.

For Shedlock, removing government sponsorship of the rating agencies "really needs to happen" to increase investor confidence.

"That’s what it would take for me to have confidence because then the markets will quickly sort this thing out," Shedlock said. "Instead, we’re going down the path of putting more regulation on top of this.”

In July, the House Financial Services Committee unanimously approved H.R. 6308, the Municipal Bond Fairness Act, requiring credit rating agencies to apply rating symbols consistently for all securities. Industry groups said the legislation would help to restore investor confidence and said a single and consistent ratings structure is "critical to bond investors" who want the ability to compare a multitude of investment options across asset classes.

"Investors have been concerned about the confusion, uncertainty and implementation issues a new system would create during this challenging time," said Dottie Cunningham, CEO of the Commercial Mortgage Securities Association.

The bill also required the SEC to create a system to measure NRSRO accuracy and to use the results to help guide its decision on when to initiate an examination of a ratings agency. However, Shedlock said the current model still reflects companies earning business based on government sponsorship rather than through the free market.

“If the big three—Moody’s, S&P and Fitch—all had to live or die on the basis of their ratings, they would be a lot better than they are,” Shedlock said. “As long as the SEC says that all debt issues have to be rated, and they have to be rated by a Nationally Recognized Statistical Rating Organization, then these problems will continue.”

S&P said it would work with market participants to improve the quality, integrity and disclosure of information on collateral underlying structured securities.

Project RESTART, for example, a proposed RMBS Disclosure Package from the American Securitization Forum, would allow investors to more easily compare loans and transactions across all issuers. The proposal follows the CMSA Investor Reporting Package model for the CMBS market.

Shedlock said greater transparency is “whitewashing” and that Moody’s Investors Service, Fitch Ratings and S&P are still “well-behind the curve” in their ratings. He said some RMBS investment grade paper continue to show delinquencies, REO or foreclosures in nearly 100 percent of the pools.

“It’s not an A-rated paper when the entire pool is delinquent,” Shedlock said. “It’s the same issue across the board. Are these companies keeping up? Are they making any effort to clean up? Are they doing it proactively or are they doing it after the fact? All of these issues are still lurking out there, and they can get away with this sloppiness as long as they get paid whether they are sloppy or not.”