Article 5.8 Doubts raised over rating agency reform

By Tracy Alloway and Christopher Thompson

Financial Times June 11, 2014

On a Friday night in New York City, the block around the Westin Hotel near Times Square heaves with activity.

On Wall Street, bullets of a very different sort are flying. And, here too, the Westin is in the thick of the action.

Fitch, one of three big rating agencies, this week criticised credit ratings given by its competitors to a securitisation containing a loan secured by the Westin - the latest instance of agencies sparring with each other over so-called structured finance deals. Such deals bundle together a wide variety of loans into bonds that can be sold to large fund managers who use the evaluations of credit rating agencies to help inform their investment decisions.

Typically, these opinions are paid for by the financial firms that create the deals. But, since the financial crisis, regulators have encouraged credit rating agencies to give ‘unsolicited' opinions on deals that they are not hired to evaluate, as part of an effort to avoid the ‘ratings shopping' that proliferated before 2008.

However, as the rating agencies trade public barbs amid a resurgence of certain types of structured products, questions are being raised as to whether these unsolicited opinions actually have much effect on investors' thinking. And are the banks that securitise loans simply taking their deals to the agencies likely to give them the highest ratings?

‘You're seeing them [the agencies] having to be vocal because there's no other visible ramification for their competitors being wrong,' says Gene Phillips at PF2, a structured finance consulting firm.

‘A preferable alternative is a system which says you can rate whatever you like wherever you like but you will lose business as a result of being wrong.

In the aftermath of the crisis, when subprime mortgage securitisations turned out to be anything but the pristine investments that their triple-A credit ratings implied, regulators rushed to reform the agencies hired to evaluate such securities. At the top of their list was encouraging the agencies to be more vocal about their competitors’ ratings by publishing their own unsolicited opinions. To do so, they created a special website for issuers to share deal data, so that competing agencies could evaluate securitised products they were not formally hired to rate.

The idea was to help expose spurious ratings and encourage smaller agencies that might help challenge the dominance of ‘the big three’ - Fitch Ratings, Moody’s and Standard & Poor’s.

Fitch’s criticism of Wells Fargo Commercial Mortgage Trust 2014-Tish, which includes a $210m loan secured by the Westin Hotel, is the most recent example of a rating agency publishing an unsolicited commentary. ‘Fitch believes a number of recently issued large loan transactions have debt levels that are inconsistent with the ratings assigned,’ the agency’s analysts wrote in the commentary.

Larger credit rating agencies, in particular Fitch, have been among the most prolific when it comes to issuing unsolicited opinions. Smaller groups such as Kroll and Morningstar have not published any unsolicited ratings or commentaries, according to their respective spokespeople.

‘We believe that [publishing unsolicited commentaries] will enhance our credibility with investors and they will encourage issuers to use Fitch more frequently,’ says Kevin Duignan, global head of securitisation and covered bonds at Fitch. ‘We think that’s healthy.’

But, while the competition between rating agencies to issue unsolicited opinions has heated up, it appears to have had little impact on the behaviour of investors or issuers, say market participants.

Indeed, there are rumblings of a return of ratings shopping - the pre-crisis practice where issuers would sound out rating agencies for their initial feedback on a deal, and then hire the agency that offered the best possible designation.

When Moody’s criticised a residential mortgage-backed security in 2011, for instance, the company that created the deal simply decided to use Fitch’s ratings instead. ‘The sponsor disagreed with Moody’s preliminary assessment of the risks attributable to the mortgage loans,’ the prospectus for the deal read.

Fitch says it was asked to provide initial feedback on the CMBS backed by the Westin loan and determined that it would have rated the safest slice of the deal AA, and would not have rated some of the riskier pieces of the deal at all. S&P and Morningstar rated the top slice of the deal triple-A. Says Mr Duignan: ‘Unsolicited commentaries may not be the best solution but they are a far better solution than remaining silent.’

FT

Source: Alloway, T. and Thompson, C. (2014) Doubts raised over rating agency reform, Financial Times, 11 June.

A major debate is whether the investing institutions rather than the borrowers should pay for ratings. After all, they would be the beneficiaries of a more robust examination of the likelihood of default without the, supposed, taint­ing of the potential conflict of interest arising from the examinee paying - a case of he who pays the piper calling the tune, it is alleged. The CRAs retort that they live and die by their reputations; they cannot be seen to be anything less than objective and impartial. Also, with lenders paying, they might decide not to publicise the rating they pay for; lack of public information could result in distortion of trading in the market or duplication of rating assessments. Egan-Jones is an example of a CRA paid by bond investors, but remains a minnow, with 95-97% of ratings conducted by S&P, Moody's or Fitch. Despite this dominance, new rating agencies are springing up to challenge the big three - see Article 5.9.