Duncan Andrews
The ratings time-bomb
Some years ago I had a conversation with the CEO of one of the big credit rating agencies which went something like this:
“Can you believe that Forbes magazine has just rated me the 35th most powerful man in the world?”
I replied “You’re kidding.”
“No, I’m just one peg below Saddam Hussein.”
How could a man who hardly anyone had heard of be the 35th most powerful man in the world?
The really crazy part is that Forbes was probably right, but how could this be?
The rise of the rating agencies all started about 20 years ago with the confluence of three big shifts in the corporate world. First, money markets began to dramatically expand and truly internationalise. Second, the obligations of directors became more onerous. This meant that if a corporation lent money, directors increasingly wanted an "expert opinion" to justify the relative risk their organisation was taking when it lent money.
Typically the average board came up with a policy which meant that management could lend 'x' amount to a AA-rated entity and 'y' amount to AAA-rated entities. In effect this meant that if a mistake occurred, directors could demonstrate that they had done their due diligence and mitigate their personal liability.
Third, securitised debt instruments began to appear. Conventional lending by banks was always limited, and inhibited, by gearing constraints placed upon them by their regulators – in Australia’s case by the Reserve Bank. Securitised debt was the answer. These were complex debt instruments, invented by investment banks, which largely circumvented the constraints imposed on banking system. Funds became increasingly available at attractive prices to a broader group of organisations.
Securitised debt is largely unregulated and has grown to such an extent that in the USA this market is believed to be as large as the entire banking system. But securitised debt is complex. It usually relies on complex credit enhancement techniques which in turn depend on complex legal arrangements to support the credit quality.
And here's the rub. The average lender/investor is not going to invest in something they have never heard of that relies on legal arrangements they do not understand. So to sell these debt instruments, investment banks went to the rating agencies. Rating agencies are the vital cog which makes securitised debt work. With the backing of a AA or AAA rating, all of a sudden there are any number of people around the world who will buy this securitised debt. Simplistically the rating meant the debt was a good credit risk.
The fundamental weakness is that the rating agencies are very profitable businesses who charge hefty fees to the investment banks (by this I mean seriously large fees) for their ratings. This causes an undeniable conflict of interest. Certainly the rating agencies understand this, but the fact remains that probably no-one benefits more from securitised debt than the rating agencies themselves.
At the risk of repeating myself, it is fair to generalise that unless the rating agency can provide at least investment grade ratings, then they are superfluous – because there will be no demand for the securitised debt product. No securitised debt, no ratings, no fees. Simple as that.
From a credit risk perspective I have never understood why so much securitised debt is rated so highly. To me it defies logic. 'AAA' means the credit quality is undoubted – that’s the formal definition to which historically only governments and the soundest of corporations could aspire.
But from an investor perspective, to have to rely on complex legal documentation (often originating in a country outside of where the paper is being sold) to justify the credit quality then a AAA rating is plain wrong. If the legal documents are fundamental, this means, by definition, that there must be a risk that the investor will need to rely on that legal documentation and the courts. That is not AA or AAA in my opinion.
The problem is that everybody, including the rating agencies, wanted to convince themselves about credit quality. It was in everyone’s interest to stretch the definition of “undoubted”.
The current mess and loss of confidence in credit markets is the chickens coming home to roost.
Duncan Andrews is a member of Business Spectator's advisory board and was founder and managing director of Australian Ratings, which in 1990 became part of Standard & Poor's Australia. He is currently chief executive of a group of private investment companies.