Tuesday, February 12, 2008

Rating agencies under fire

By: Daryl Ching, Clarity Financial Strategy

The rating agencies have been in the spotlight since the market freeze in August and have taken action to appease the public. Boyd Erman published an article in the Globe and Mail called “Regulators may clamp down on rating agencies”. The International Organization of Securities Commissions (IOSCO) may toughen the code of conduct for credit rating agencies by requiring more disclosure of rating processes, prohibiting the practice of consulting on the design of securities and requiring more research into the assets underlying complex securities.

S&P recently announced 27 separate measures to change the way they operate addressing enhancing governance, strengthening analytics, increasing transparency and educating the public. As an example, to address the conflict of interest, S&P proposes to rotate analysts so they don’t get unhealthily close to the issuers who pay for their own ratings. Moody’s has proposed to move from a letter grade system to a numerical system for structured finance. DBRS is currently reviewing the Leveraged Super Senior CDO methodology and has made a shift to requiring Global Style Liquidity for ABCP conduits.

It is worth noting another criticism of the rating agencies – an over reliance on quantitative financial models. We hear stories about the rating agencies hiring PHDs in math and physics to develop sophisticated models for the various asset classes. In the traditional securitization world, the rating agencies get comfortable with “stress testing models”. When evaluating a basket of mortgages, they will make assumptions such as an increase in losses, an adjustment in prepayment rate, a drop in real estate values, etc. Provided there is sufficient credit enhancement to protect against these stresses, the structure passes as AAA. For the Leveraged Super Senior CDOs, a key component that is stressed is correlation. As long as there was sufficient diversification among industries, geography, etc., these models would pass the test.

While the quantitative models have merit, what is missing is more emphasis on the practical approach. If mortgages are being granted to individuals in the US with low teaser rates who cannot afford them, it may not be enough to stress losses four times or to rely on a model. With the LSS CDOs, in a severe credit crunch such as the one experienced recently, correlation for defaults can easily be come 1 across all industries. Some transactions relied on hedging with credit insurers that are rated AAA. When these insurers are insuring debt at a multiple of their capital base, it is worth taking a step back and saying, perhaps this insurance is not worth a AAA rating.

The rating agencies like to rely on models because it automates processes and makes the ratings easier to do. Especially, in some cash CDO transactions that reference a hundred RMBS bonds, it would an onerous process to review the underwriting practices of every mortgage servicer. However, we have learned that this practical approach of looking at all the qualitative factors in a transaction is absolutely essential.

We certainly hope that JP Morgan and the rating agencies picked to rate the restructured notes in the Montreal Accord will apply this practical approach. It is no longer sufficient for the rating agencies to rely on old methodologies to rate structured finance products going forward.

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