Experts: Rating Agencies Need to be Smarter in Evaluating Investments

By Natalie Dolce

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LOS ANGELES-Credit ratings are used by investors, issuers, investment banks, governments and broker-dealers. For investors, these rating agencies increase the range of investment alternatives and provide measurements of relative credit risk. But over the years, especially after the 2007-2009 financial crisis, and more recently, ratings downgrades during the European sovereign debt crisis of 2010 and 2011, they have drawn some criticism regarding their role in the financial system.

Rich Walter, president of Faris Lee Investments, tells GlobeSt.com that “the rating agencies provide the only way today for investors to rely on the underwriting of a third party to make credit decisions.” Walter says the system is by no means perfect, noting that “credit ratings require a multitude of analysis and don’t necessarily look at future trends in determining these.”

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Marcelo Bermúdez, president of Figueroa Capital Group, a subsidiary of Charles Dunn Co., tells GlobeSt.com that ratings agencies are not too dissimilar from the No Child Left Behind Act. Everyone wants an easy rubric to judge whether or not a student is worthy of going on to the next grade, he explains, but “Talk to any teacher and they will roll their eyes when you mention No Child Left Behind. The same goes for bankers when you talk about ratings agencies.”

Walter

HOW RELIABLE?

The ratings a bank receives “rarely reflect what is really going on at the bank or any other operating entity for that fact. They are unreliable at best,” adds Bermúdez. “Banks and other lenders answer to several alphabet soups of federal and state entities all pulling in different directions. Getting clear answers on governance and operations is near impossible.”

In response to that, Fitch Ratings tells GlobeSt.com that “No firm providing opinions about a future outcome can be correct 100% of the time, but most of our ratings outside US RMBS and related CDOs have performed well through the crisis and continue to do so. Where our ratings did not perform well, we have made substantial changes to our people, processes and methodologies such that we are a much stronger firm today than we were before 2008.”

According to Tom Muller, a partner in the real estate and land use practice group at law firm Manatt, Phelps & Phillips LLP in Los Angeles, ratings agencies came into being in order to provide a service intended to let investors shortcut the difficult and time-consuming process of evaluating investments for themselves. “While their ratings are helpful, investors have learned the hard way that they placed too much reliance on those ratings,” he says. “Real estate securitization is coming back only very slowly partly because the rating agencies have lost their credibility, so investors feel they have to underwrite the loans in the pool themselves.”

Bermudez

Rating agency Standard & Poor’s tells GlobeSt.com that “Ratings can be a useful tool for investors in assessing credit risk but they are not investment advice or a substitute for investors doing their own research.”

Fitch too supports efforts to reduce over-reliance on ratings. “Market participants should—and for the most part already do—use our ratings as one among many factors in forming their own decisions.” The agency adds that while it is always looking for ways to strengthen its analysis, “ratings continue to be an important component of investors’ decision-making process, and market participants are using them as a complement to their own fundamental credit analysis—rather than a substitute for it. We see increased demand from investors through our subscriptions, which were up this year both in terms of new subscribers and retained subscriber rate which increased to 96%.”

Moody’s tells GlobeSt.com that it too has long supported efforts to reduce overreliance on credit ratings, including reducing regulatory references to ratings, and that it “continues to see strong demand for its ratings and research based on the quality and scope of its credit analysis.”

Muller

TIME FOR SOME COMPETITION

Muller agrees that because there are so many investment vehicles available in the economy, and so many of them are so complex, the market certainly will continue to need rating agencies of some sort. In fact, he says, more would be better since “it would create more competition, and might force the agencies to be smarter about how they evaluate investments.”

Fitch couldn’t agree more. “We believe strongly in healthy competition, as markets benefit from a diversity of credit opinions,” the agency tells GlobeSt.com. “The most important point in this area is that there must be a level playing field. Any rating agency must establish a reputation for independence, and the management of conflicts of interest.”

Standard & Poor’s tells GlobeSt.com that it too welcomes competition, “because the market benefits from a diversity of opinions on credit risk that are independent, transparent and comparable across asset classes and geographies.”

But like other sources, Muller says improvements are certainly needed. “The rating agencies—and the market in general—were too impressed with geographic and product diversification as mitigators of risk, and paid far too little attention to the inevitability of nationwide cyclical real estate recession.”

ACCOUNTABILITY

To Gary Mozer, principal and managing director of George Smith Partners, the bottom line is that rating agencies have had no true accountability. “They can say a sub-prime mortgage pool has a AAA rating and that the US government has a lower rating than that,” he says. But the positive thing, according to Mozer, is that “the rating agencies’ system benefits from a third party evaluating financial instruments. Dodd-Frank legislature tried to change that responsibility, but in the end, the market is the arbiter.”

Mozer

Because there are just four or five agencies, Mozer adds, it creates an oligarchy. “Beyond that, the fact that these agencies are competing to rate everything in the entire financial system means that issuers will want to select the most aggressive agency, which is an enormous inherent conflict in the system. The ratings agencies are monetarily rewarded for their ‘services’ or rating,” he says. “The financial institutions are rewarded for ‘better’ ratings, ergo, the financial institutions are monetarily rewarded for selecting the most aggressive agency.”

Fitch points out that “No payment model is completely immune to conflicts of interest, whether from investors, issuers, governments or regulators. While Fitch recognizes the potential conflicts of the ‘issuer pays’ model, we believe that these are effectively managed through a broad range of policies, procedures and organizational structures. An 'investor pays' model, for example, contains numerous and less transparent conflicts, given that most major investors have a vested financial interest in the level of ratings and many are themselves rated entities.”

Categories: West, Capital Markets, Special Reports, Los Angeles