Sunday, November 27, 2011

EU should stress test the Rating Agencies, not just the Banks

Finally, someone is paying attention to one of the main problems of the 2008 financial meltdown: the rating agencies. Asleep at the switch, these agencies were caught napping when a whole industry – the US subprime industry – imploded under its own rickety structure, dragging down the world's banking system.

An Industry Wide Failure in 2008:

What is very clear is that the investment bankers, the lawyers working for them, the fund managers, the commercial banks, the stock market authorities, and the rating agencies were all complicit in the debacle, because they all were parties to the erosion of proper credit standards.

The securitized instruments that allowed the subprime market to arise were in the beginning tightly polices by the agencies. S&P and Moodys applied stringent tests to determine the probability of default on credit card and mortgage pools, basing a large part of their ratings on past credit behaviour of the debtors. To gain an investment grade rating, the vehicle had to meet tests which were multiples of part default ratios.

How the  Rot set in:

And then the rot set in. More and more fancy structures were used, each one outdoing the other in slicing and dicing the risks, adding layers and layers of higher risk investment segments to the vehicles. Outside guarantees by insurance organizations were added, to spread the risk beyond the assets (credit card debt and mortgages), and investors could pick and choose which range of risk they would like to assume, with corresponding higher levels of yields.

But the industry itself was corrupted, by any objective measure. Banks originated mortages by lending money to people who had to sound credit histories and little chance of actually paying their mortgages. The banks then took the origination fees and ran – dumping the mortages by selling them to the securitization vehicles, which were rated by the agencies and then on-sold to funds and other investors.

Junk In, Junk Out – an old lesson relearned but too late:

The fallacy underlying this whole exercise was a complete distortion of the normally sound investment strategy of diversifying your risks. This strategy was stretched out of recognition  because the diversification became the on-selling of risky assets to a wider set of investors, instead of the investment of funds in a variety of assets in order to reducing risks to the whole portfolio by such spreading of risks.

Bad assets were widely sold and most people in the industry assumed that this in and of  itself would protect investors. The vehicles became huge securitized ponzi-like schemes, just waiting to collapse.

And at the heart of the industry were the gatekeepers of credit, the rating agencies, who failed in their job of properly analyzing credit risks of these instruments.

EU eyes the culprits:

Now the European Union is thinking of taking steps to control these agencies:

The European Commission has put forward stricter rules for the credit rating agencies that rank countries' and companies' debt.

It says the agencies, including Standard & Poor's, Moody's and Fitch, should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes...

The EC internal market commissioner, Michel Barnier, said the agencies, which are privately owned by investors, had a serious and widespread effect on individuals.

"Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens," he said. "They are not just simple opinions."

He also said they were not infallible in their assessments and had made "serious mistakes" in the past.

The steps the EU wants to take consist of tighter control:

"We can't let ratings increase market volatility further."

He said any agency that "infringes, intentionally or with gross negligence, the CRA [Credit Rating Agency] regulation, thereby causing damage to an investor having relied on the rating",
should have the case taken to the courts.

He said one of the Commission's aims was to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process...

"Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes. I also want to see increased competition in this sector," said Mr Barnier.

This would include introducing a general obligation for investors to do their own assessment.

These steps are welcome, but they are not enough.

Restoring the Primordial Power of the Politicians:

"The consequences of the 2008 crisis are far from being erased," he added.

He argued that politics needed to regain its "primordial" power over markets, and said the Commission aimed to help achieve this with increased capital requirement ratios, better financial regulation and new measures to protect consumers.

But he warned: "We can't be over-rushed and we can't achieve all things overnight."

Well said, and the best of luck, says The Cat.

Stess Tests for the Methods used by the Rating Agencies:

But the EU should go one step further.

Just as the authorities are now imposing stress tests on the banks, designed to test their ability to weather different types of turmoil in the markets, so too should they impose stress tests on the methods used by the rating agencies to rate debt and other instruments.

The EU should require every rating agency to submit its financial and other tests to an EU supervisory body each year. That body should then examine the tests used by the rating agencies to determine creditworthiness of instruments (bonds, derivatives, shares) for their soundness, and match the tests against various assumed circumstances,  much like the banks' health is being tested in the stress tests. Increase inflation rates, the default rates, a drying up of credit, economic downturns and other factors, and see how the rated securities perform.

And insist on changes to the rating agency methods to make sure the credit ratings do what they are supposed to do: advise investors of credit risks in the securities.
Only then will we have a sounder financial system.

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