November 2008

WIDENING THE WEB: Credit Risk Agencies

Fund managers are under increasing pressure to identify credit risk, but are now choosing to rely less on traditional ratings agencies. Angele Spiteri Paris reports ... When things go awry, it is only human to point the finger of blame. Following the sub-prime crisis in the summer of 2007, attention first turned towards the credit rating agencies, and the attention has lingered there ever since.

The credit ratings industry is dominated by three large firms that rate the risk of debt within companies and securities. The ratings they issue are a major indication of investability for fund managers.

Their methodologies have been called into question as well as the speed with which they reflect changes to ratings.

The EC was concerned enough about how these three ratings providers could affect market stability that it issued proposals suggesting regulation of the rating agencies needed to be more stringent.

So far the finger of blame has not pointed to fund managers, though. But the EC is asking whether fund managers and other investors are themselves too reliant on the main three agencies, namely Fitch Ratings, Moody’s Investors Service and Standard & Poor’s, when taking investment decisions.

Clients of fund managers, who now have a heightened sense of credit risk, are also asking this same question of their money managers. “Our clients are expecting us to not rely wholly on ratings agencies but to look at other measures of risk,” says Mark Dickson, a director at Blue Sky Asset Management. “They also expect us to be talking to companies directly to find out where their liabilities might lie.”

Further, fund managers themselves are taking a greater interest in the credit worthiness of their custody banks.

A number of responses to the recent EC consultation argue that investors should expand their sources of credit risk – for example, by using smaller boutique agencies or by employing more internal checks.

Some managers already do this. Fixed income houses like Pimco and M&G Investments have a slew of in-house analysts each assigned to different sectors of the credit market. The analysts monitor their assigned credits and give a rating that supplements those of the agencies.

Alternative approaches
Increasing the number of analysts would expand a fund managers’ breadth of credit coverage and allow for more in-depth reports. Individual analysts would have fewer credits and companies to cover, and therefore more time for face-to-face meetings with management.

But additional human resources are not the only option. Another way of complementing ratings agencies is by looking at the credit default swaps (CDS) market, which measures the likelihood of default on corporate bonds. This is what StatPro, a risk management firm, does and it argues that data is more objective than that derived from human-driven ratings.

Dario Cintioli, CEO Italy and global head of risk, says: “With ratings, you are relying on the opinion of a handful of people, while in the CDS market there are a number of traders with even more analysts working behind them.

“One of the sources of the current crisis is that the risk management structure of investment banks and other financial firms was based on the opinion of a handful of analysts. It is as though you had a massive castle built on very weak foundations.”

The EC will consider supplementary providers of ratings and data as part of its own consultation, which closed recently. But problems are likely to occur in the detail of how to regulate ratings. Critics said the consultation was a hurried, knee-jerk reaction to the sub-prime crisis. For example, the sub-prime debt securities that started the crisis were rated in the US, meaning European regulation would have been limited in its efficacy to shield Europe. Now that banks are spewing forth toxic assets at the speed of a 40-gigabit-per-second Internet connection, the EC’s action could be seen as an attempt to close the stable door after the horse has bolted.

To curb the excessive reliance on ratings, the EC makes three suggestions:
  • Require regulated and sophisticated investors to rely more on own risk analysis, especially for (relatively) large investments
  • Require that all published ratings include ‘health-warnings’ informing of the specific risks associated with investments in these assets
  • Examine the regulatory references to ratings from ratings agencies and revisit them as necessary

Many submissions to the consultation aimed to show how regulation could be too dogmatic.

According to Moody’s: “Prescriptive and detailed legislation could create a false sense of security among market participants that credit ratings [that are] published in such a heavily regulated environment are government-approved and therefore will be viewed as assurance rather than an opinion about an entity’s creditworthiness.”

Similarly, S&P suggests: “The commission should carefully consider whether any elements of its proposed regulatory scheme may have the unintended side effect of fostering very undue reliance on credit ratings that it seeks to discourage.” This could particularly be the case in relation to the ‘health warnings’.

A number of submissions have called for the agencies to be regulated using a principles-based approach, which can be adapted more deftly.

Some critics say it was a rules-based approach that got the agencies into trouble in the first place. Due to the complexity of structured products, rating agencies had developed a one-size-fits-all approach to rating them. They simply did not have the resources to dig deeper into every issue that passed through their doors.

This, say some industry experts, left the opportunity wide open for investment banks to essentially game the system and garner the rating they desired.

Stuart Thomson, economist at Resolution Asset Management, says: “Ratings agencies were very much rule based. Although they said they did account for subjective elements, the ratings were essentially modelled on the basis of [banks’] financial ratios.

“This meant they were very easy to game and companies and banks were able to effectively fix the ratings they received.”

Cintioli, of StatPro, agrees. “This practice is completely legal. The methodology the ratings agencies use is public so it is almost obvious that issuers are going to structure their products to get a AAA rating. This is not necessarily done in bad faith, but it is a fact of the industry.”

Jonathan Brogden, a partner and litigation specialist at Davies Arnold Cooper, a City law firm, believes
that to a large extent the banks did not fully appreciate the exposures that were buried within their investment products.

Lack of understanding
“If they positively knew their products contained toxic elements and they took steps to deliberately conceal them from investors, then that’s fraud,” he says.  “However, it appears more likely that they just didn’t fully understand their own product. It would now appear that no one was really putting much thought into it. This state of affairs does, however, still leave banks open to criticism and claims.”

Rating agencies have, not surprisingly, defended themselves in the consultation. S&P’s executive vice president Vickie Tillman voiced fierce opposition to the “sweeping and unsubstantiated comments concerning the apparent failure of credit rating agencies to perform their role properly within the structured finance markets”.

She moves on to express her disappointment at the tone of the introductory remarks in the consultation, “particularly the suggestion that credit market turbulence reflected a lack of independence or integrity on the part of credit rating agencies”.

Other respondents feel they were not given sufficient time to respond. Johan Barnard, the deputy director of financial markets policy at the Dutch Ministry of Finance, says: “A thorough regulatory impact assessment is lacking which makes it difficult for us to judge this proposal. Furthermore, consultation should leave sufficient time to provide a decent assessment.”

Scrutiny of ratings agencies was already taking place prior to the sub-prime crisis. This consultation will probably hasten any change. Charles Cronin, of the CFA Institute, says: “I think the whole world’s changed now. We will be in a situation where investors need to really do their homework and find out what is in the product before they buy it.”

Ratings and related market data are very important in a highly sensitive market environment as is being witnessed now – yet ironically they are not much use at present, according to some.

“Ratings are largely meaningless at the moment because the markets are changing on an almost daily basis,” notes Brogden,
of Davies Arnold Cooper. He suggests that confidence in ratings may only properly return once markets stabilise, but at the moment it is anyone’s guess when that will happen. ©2008 Funds Europe

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