Rating agencies are coming under fire on both sides of the Atlantic following the US subprime market collapse. Helen Yates asks if the industry should question its reliance on ratings.

In scenes straight out of the Great Depression, customers queued for hours outside branches of Northern Rock in the UK. The incredible bank run and more recently, the crises faced by giants of the investing banking world, Merrill Lynch and Citigroup, were a result of the global credit crunch. Nobody knows what the ultimate outcome will be. Some speculate a global recession is in the offing and that other giants may fall. Ultimately, someone will take the blame.

“These guys are going to get to keep all the money even though they failed the exam,” accused the CEO of a Bermuda-based reinsurance company. The subprime crisis has led to fierce accusations that the credit rating agencies failed to do their job. They are accused, among other things, of rating subprime securities too highly and then not reacting quickly enough when the market took a tumble.

The insurance and reinsurance industry is expected to “weather the storm well”, according to Keith Buckley, group managing director and global head of insurance at Fitch Ratings. Nevertheless, for a business that relies so heavily on the opinions of rating agencies, the questions being asked in the wake of the subprime collapse are pertinent. Are there worrying conflicts of interest? Ultimately, should greater due diligence, beyond the ratings, be used to inform decisions?

Pass the parcel

The subprime lending market is where specialised unregulated lenders in the US grant mortgages to individuals with poor credit histories. Clearly, there is a higher risk of default and therefore the risks are spread across the capital markets. They are bundled together, securitised and passed on to investors in the guise of asset-backed and mortgage-backed securities. For a while, low interest rates and rapidly rising house prices contributed to the market’s growth.

Investors looking for above-average returns in the low-interest rate environment welcomed these high-yield products. They proved particularly popular with hedge funds. The securitisations, or collateralised debt obligations (CDOs), also added a new string to the rating agencies’ bow. They could charge a steeper price for rating these complex and highly leveraged products. Nearly $1trn worth of subprime mortgages was issued in 2004 and 2005 alone, representing some 10% of the entire US mortgage market.

And so it went on, until the bubble burst. As house prices began to fall at the end of November 2005, the warnings about subprime products got louder. In Spring 2007, the market finally, and spectacularly, collapsed (see box on page 15). “You could argue that many investors – whether they were insurers or banks, or pension funds – fell victim to the too highly rated securities that were backed by subprime mortages,” says Bob Hartwig, president and chief economist of the Insurance Information Institute.

In an online blog, one New York-based banker summed up the subprime saga thus: “When the losses have been digested, lessons learned and some fraudulent practitioners are doing porridge, the next wave of business school undergraduates will learn about the wonders of securitisation and the damage it caused. This is before they are let loose on the same global banks that invented it in the first place. And perhaps the brightest in the class will be able to explain how on earth a pool of low-grade subprime mortgages issued to homeowners with no money down and no proof of income could, thanks to Wall Street wizardry, be sliced and diced such that fully 75%-80% of it was awarded bullet-proof AAA credit ratings, when in fact the underlying creditworthiness was, in short, absolute crap.”

Bullet-proof AAA ratings

“I guess you could say the rating agencies not only led the whole crisis they really were the ones who allowed this thing to initiate in the beginning,” says the Bermuda-based reinsurance CEO. “Because without the ratings those securitisations just couldn’t have taken place.” He accuses the rating agencies and banks of collusion over the creation of synthetic capital. He is particularly angry at the prices some of the agencies charged for rating subprime securities. “I heard that that rating of these subprime mortgages was so complex that they were charging a multiple of the regular fee – and in some cases it represented billions of dollars of additional revenue for these guys.”

“When the losses have been digested, lessons learned and some fraudulent practitioners are doing porridge, the next wave of business school undergraduates will learn about the wonders of securitisation and the damage it caused

The European Commission announced in August it was investigating the rating agencies. The review will cover issues such as governance, the management of conflicts of interest, the resourcing of the agencies and ratings migration, focusing in particular on segments of the securitised mortgage asset and subprime market.

In the US, the Securities and Exchange Commission is investigating whether rating agencies “were unduly influenced by issuers and underwriters” and turned a blind eye to the risks attached to CDOs and other subprime securities. The probe is also focusing on whether the rating agencies followed their stated procedures for managing conflicts of interest.

Legal proceedings are also underway. A Moody’s shareholder lawsuit claims the rating agency did not tell investors it “assigned excessively high ratings” to bonds backed by subprime mortgages and is seeking class action status. The rating agency’s third quarter profits missed analyst’s estimates and its share price fell 3% in October. Financial analysts say it is particularly sensitive to the credit markets.

At the reinsurance industry’s Monte Carlo Rendez-Vous in September, Moody’s analysts refused to comment when asked what impact the subprime collapse would have on the company’s reputation. In other statements, both Standard & Poor’s and Moody’s have strenuously denied any wrongdoing. Vickie Tillman, executive vice president of credit market services for Standard & Poor’s, in a statement titled “Don’t blame the rating agencies”, wrote: “Reputation and integrity are our most valuable long-term assets, which would make it imprudent for S&P to provide anything other than fair, objective and independent ratings opinions.” She believes the charges reflect “a misunderstanding of the work carried out by rating agencies”.

Finger-pointing

Is finger-pointing inevitable whenever there is market turbulence? Human nature is such that blame and accusations usually follow a nasty surprise. In the aftermath of Hurricane Katrina the catastrophe modellers took a hammering for failing to predict the extent and incredible cost of the disaster.

“It’s a bit like the risk modellers, it’s not an exact science” says Julian Samengo-Turner, co-unit leader of broker Integro’s international insurance and reinsurance operation. “Every event is slightly different and in many ways they can never be perceived as right. They absolutely get crucified when it has gone wrong and you always remember what they’ve got wrong. When they get it right it doesn’t make news.” He argues that we shouldn’t be scared of conflicts of interest but “should be diligent and vigilant as to how to handle the conflict of interest and be completely transparent about it”. He argues that if rating agencies were not allowed to make money they could not afford to employ the best talent or resources.

Hartwig says they can’t win. “Companies blame the ratings agencies for being too stringent, but at times like these people blame the rating agencies for not being stringent enough. So they’re pulled in both directions quite frequently.” He says it is inevitable, given the thousands of ratings issued every year, that some of them will be wrong. “In some cases you’re going to get them quite spectacularly wrong. But generally speaking they do call it correctly.”

Fitch’s Keith Buckley sees the scrutiny as a natural course of action following such a large market disturbance. “It’s always common when there are credit events that all parties are looked at that are involved,” he explains. “I think it’s natural that people would be asking about the rating agencies and our actions and this is normal and understandable and something we try to respond to and remain as transparent as we can.”

Could the shock of the subprime collapse and anger levelled at the rating agencies be deflecting some of the responsibility investors themselves are currently feeling?

“Just as the catastrophe modellers hit back at critics after Katrina, the rating agencies are keen to argue that this is a case of the workman blaming his tools

Are all ratings created equal?

The rating agencies are keen to stress that credit ratings are just an opinion. “That’s an important distinction as in the US an opinion is protected under our first amendment as free speech,” explains Hartwig. “They will tell you it is an opinion and if they are sued over a faulty rating they will say it’s an opinion.”

Just as the catastrophe modellers hit back at critics after Katrina, the rating agencies are keen to argue that this is a case of the workman blaming his tools. S&P has added a new section to its website to inform interest parties about the rating process and what the ratings are intended to inform.

“There are maybe some users of ratings that don’t have a full enough appreciation for what the rating is trying to communicate and what it isn’t,” says Buckley. He sees the current investigations as “an opportunity for a very healthy dialogue to identify areas where perhaps there were misperceptions”. He emphasises that ratings are not intended to communicate the changes in the market value of securities but are intended to communicate the likelihood of default.

One argument is that subprime investors should have conducted better due diligence and relied less on the ratings. If these lessons are transferred to insurance and reinsurance purchasing, buyers should be doing the same. “When a triple-A rated bond is yielding substantially high and someone looks at it like it’s a sovereign bond – it’s not and you know it’s not,” says Samengo-Turner.

He believes there are clear lessons to be learnt by the industry. “In a soft market, people are going to arbitrate their position with cheap reinsurance,” he warns. “Cheap reinsurance doesn’t mean it’s bad reinsurance but if markets see somebody writing substantial amounts at a massive discount the wiser buyers tend to allocate a certain amount of capacity, notwithstanding their rating.” Those that go in two feet first but feel they have protection because the reinsurer has a good credit rating could be in for a nasty surprise, he warns.

“The issuance of a credit rating does not absolve the portfolio manager from his duty of performing adequate due diligence.” In addition, relying on ratings alone is no longer enough to protect you from the scrutiny of your board of directors when things go wrong, warns Hartwig. “Good portfolio managers do their due diligence – they don’t rely on a single rating. Good risk managers don’t rely on a single rating when they’re evaluating placing cover with an insurer.”

Hartwig says it is unlikely that any of the current investigations will find culpability, but predicts it could lead to greater disclosure requirements. This is something the CEO of the Bermuda reinsurance company would welcome. “They make up the rules, there’s no federal oversight, and maybe that’s the problem,” he says. “The banks are making tonnes of money, [the rating agencies are] making tonnes of money and the investor – and let the buyer beware – is relying on these ratings because if he knew what he was doing he wouldn’t need the ratings.”

Clearly, should the SEC or European Commission find any evidence of wrongdoing it will have dramatic consequences. As Samengo-Turner puts it: “If their integrity was found to be in doubt, their business would collapse immediately and they’d almost become a discrediting agency.”

Timeline of subprime woes

* August 2005 through 2006: Higher borrowing costs start to impact the US housing market. Defaults on subprime mortgages increase.
* 2 April 2007: Subprime lender New Century Financial files for bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of bad loans.
* 18 July 2007: Bear Stearns tells investors they are unlikely to get any money back from the two hedge funds it has had to rescue.
* 27 July 2007: The subprime collapse begins to affect global stock markets. The Dow Jones loses 4.2% in five sessions, its worst weekly decline in nearly five years.
* 6 August 2007: American Home Mortgage, one of the largest US independent home loan providers, files for bankruptcy.
* 9 August 2007: The European Central Bank pumps ?95bn into the market after French bank BNP Paribas and Dutch bank NIBC reveals significant subprime exposures.
* 17 August: The US Federal Reserve cuts the interest rate at which it lends to banks by a quarter of a percent to help banks deal with credit problems.
* 26 August: German regional bank SachsenLB is quickly sold to Germany’s biggest regional bank, Landesbank Baden-Wuerttemberg after it came close to collapsing.
* 13 September: UK building society Northern Rock is granted emergency funds from the Bank of England. This leads to a bank run as customers fear losing their life savings.
* 24 October: Merrill Lynch reveals an incredible $8bn subprime hit in its third quarter results.