[A-List] Financial regulatory crisis: ratings analysts

["Keaney Michael" <Michael.Keaney@xxxxxx>]

As this article begins, up to now few have given much thought to the
credit ratings analysts and their role in the current crisis. Of course
recently the Japanese finance ministry has been conducting a sort of
trench warfare against the agencies, but this has not attracted much
official sympathy. After all, these Japanese, they're crony capitalists,
aren't they, and their entire economy is poised on the edge of a
precipice atop a mountain of debt, isn't it? Perhaps there are good
reasons for US state bodies to clip the wings of the credit rating
agencies before similar stories start to appear about the US fiscal
position, what with record consumer debt, plummeting dollar, record
trade deficit, ballooning fiscal deficit, etc., etc.


The final arbiters of Wall Street
By Vincent Boland
Financial Times; Jul 23, 2002

The reputation of theresearch that Wall Street produces has never been
lower. But a report last week ought to send a shudder down investors'
spines.

Moody's Investors Service, which specialises in assessing the
creditworthiness of companies and governments, has discovered, in a
study of 771 US companies, that most have a ticking time-bomb somewhere
in the agreements they have struck with lenders. These agreements
contain "ratings triggers" - clauses that benefit the creditor or bank
if a company's credit rating is cut.

These companies have financial arrangements similar to those that
brought down Enron. The collapse of the Houston energy trader has made
investors familiar with ratings triggers. So the startling fact about
Moody's report is not that other companies employ rating triggers but
that they have not been disclosed.

As well as alerting investors to a development they surely need to know
about, the report is significant in another respect. After a damaging
period when their actions at Enron brought ratings agencies much
criticism, they appear to be on the front foot again. In a climate of
deteriorating credit quality, fishy accounting and a stampede out of the
stock market, investors know that one of the few remaining sources of
must-read research is the people often thought of as the brainiest geeks
in the financial markets.

The many critics of Moody's, Standard & Poor's and Fitch Ratings will
grit their teeth at that news. Enron aside, the collapse of the
telecommunications industry has, on the whole, not been their finest
hour. "I would love for us to have caught the telecoms downturn a year
before it happened - but we didn't," says Paul Taylor, a managing
director at Fitch. "We didn't spot how high the telecoms bubble would
go."

But the rating agencies are emerging from the telecoms mess and
corporate America's wider crisis in better shape than other pillars of
the financial markets, such as investment banks and auditors. Senior
executives in the industry admit that business is flourishing as more
companies seek credit-worthiness ratings.

Investors, too, say the need for intelligent and timely comment and
opinion on the increasingly complex credit markets is greater than ever.

This raises two questions. The first is whether the record of the rating
agencies in recent years makes them the best people to provide such
opinion. The Enron case is instructive - and there are more recent
examples of actions by the agencies that have drawn criticism.

In its death throes, the Houston energy trader needed at all costs to
maintain its investment grade rating (a ranking of creditworthiness
ranging from Aaa/AAA to Baa3/ BBB minus) to prevent the ratings triggers
from taking effect. Thus the agencies had access until the bitter end to
Enron's top executives. Based on the information they received, they did
not cut the rating, although they said they would if a merger of Enron
and Dynegy, and a capital injection, did not take place.

The agencies' actions on Vivendi Universal are also a case in point.
Some investors accused them of adding to the media company's woes by
cutting its credit ratings and warning of probable future cuts. The
moves coincided with the ousting of Jean-Marie Messier as chief
executive. A fund manager at a $120bn (ý76bn) fixed income asset
management firm in New York, with a substantial holding of Vivendi debt,
says the ousting of Mr Messier was "non-fundamental" and should not have
contributed to a lowering of its creditworthiness.

Yet their stance on Vivendi, and Moody's report on ratings triggers last
week, can be seen as part of the response of the credit rating agencies
to the Enron effect. Ray McDaniel, president of Moody's, agrees that
Enron was a watershed for the industry but argues that critics
misunderstand the role they play in assessing creditworthiness.

After the collapse of Enron, all three agencies are beefing up their
forensic skills. But Mr McDaniel insists that investors must not view a
credit rating analyst as a sort of Eliot Ness of the financial markets.
That has not been, and never will be, their role.

"We accept that we have a broader set of responsibilities and a need to
ask tougher and more specialised and detailed questions," he says. "But
we still do not believe we are going to be in a position systematically
to detect fraud. Full and fair financial disclosure is critical for us
to do our jobs, just as it is critical for many others in the market to
do their jobs."

Investors who have lost money in the credit markets, such as the Vivendi
investor above, are also quick to criticise. However, Brad Thomas, chief
risk officer at the US Central Credit Union, which has $30bn invested in
fixed income securities, argues that some investors are too dependent on
the rating agencies and fail to do enough of their own research. "The
rating agencies are one piece of the puzzle in forming an [investment]
opinion," he says. "We're very comfortable with that. Investors need to
accept the rating agencies for what they are, which is one of a variety
of tools."

The second question raised by the growing influence of the credit rating
agencies is whether the industry's structure needs an overhaul. Moody's,
S&P and Fitch are not the only credit rating agencies on Wall Street but
they are the only ones with the status of "nationally recognised
statistical ratings organisations" (NRSROs). The Securities and Exchange
Commission, the US financial regulator, is under pressure either to
expand the number of NRSROs or to get rid of the distinction altogether.

Lawrence White, professor of economics at the Stern School of Business
at New York University, believes the distinction needs to be dropped. It
was introduced only in the 1970s by the SEC, long after rating agencies
were set up and at a time when there were many more of them. Since then,
the industry has been reduced to three recognised participants (Fitch is
the result of a series of four mergers).

Prof White argues that the NRSRO status is simply a way of coddling the
three agencies and stifling competition in what should be an industry as
competitive as any other.

"There is a wall of regulatory protection that has built up around the
rating agencies," he says. "The SEC needs to end the NRSRO requirement
and let the capital markets make up their minds which is a good rating
agency and which they can ignore."

Mr McDaniel says Moody's would welcome more competition but that it
needs to be on the basis of the quality rather than the quantity of
credit ratings because of the NRSROs' role as "gatekeepers" to the
financial markets. "It's very difficult to regulate rating quality: it's
an opinion business, a forecasting business," he says.

Prof White, a former regulator himself, argues that a fundamental
problem of the business of assessing creditworthiness is the "cliff"
between an investment-grade rating and a sub-investment grade or "junk"
rating.

"This is a distinction drawn by banking regulators and the SEC" that
ought no longer to be necessary, he says. He argues that bond portfolios
should be treated the same way for regulatory purposes as loan
portfolios at banks, which are not assessed individually by the credit
rating agencies.

Such a radical step seems unlikely, especially now that the SEC is
swamped by scandals and priorities that have a more immediate effect on
investors. But that does not mean that there will not be change at some
point.

"I would be surprised if the SEC weren't looking at the ratings
industry," says Mr McDaniel. "My understanding is that they are not
primarily concerned with competition so much as with greater investor
protection and market integrity. These are our concerns too."