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Bloomberg reports:

Ratings companies face rules including one prohibiting them making recommendations on the way products they grade are structured, the Madrid-based International Organization of Securities Commissions said today. IOSCO, the main forum for more than 100 securities regulators worldwide, said there should also be independent reviews of the way firms assign ratings.
…
Ratings companies will have to “differentiate ratings of structured finance products from other ratings, preferably through different rating symbols,” the regulators said in an e- mailed summary of the code.
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Fitch said April 29 it received “limited interest” from market participants in adopting a different rating scale.
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Market participants who responded, including investors together holding more than $9 trillion in fixed income securities, “overwhelmingly” rejected the idea of a separate rating scale for asset-backed securities, Moody’s said May 14.

Nobody in their right minds really cares about a different rating scale for structured instruments – this is simply cosmetic nonsense, invented to persuade the gullible public that the Wise Regulators are Taking Firm Action. I would certainly not expect any regulator to pay the slightest attention to the overwhelming majority of credit professionals who think the idea is just a touch on the rinky-dink side.

In their “Global Structured Credit Strategy” report of May 13, 2008, Citi’s Structured Credit Products Group opined:

So we repeat the plea that we made in our earlier note4 when discussing rating agencies’ proposals for reforming their criteria in light of substantial ABS CDO downgrades. We see the emphasis on expected loss — and the comparability this creates between structured and flow credit ratings — as a tremendous advantage. Unquestionably, give analysts greater powers, and create governance procedures to make them more independent. By all means, add additional dimensions (or even pictures of return distributions) to capture tail risk. (We were thus more supportive of Moody’s proposals for providing an additional “volatility” dimension, leaving the “core” rating still intact yet providing important new information).

This makes sense … I would consider a second dimension in credit ratings to be valuable advice and I would take such advice seriously when formulating my own views. This would, however, require some thought and consideration on the part of third parties to be useful, and requiring such thought and consideration would make it virtually impossible for untrained bank tellers to sell the product; and one purpose of regulation is to make all investments plain vanilla, so they can be sold efficiently with huge profits by banks, which will in turn enable them to hire even more ex-regulators.

This is important! IOSCO notes in its press release announcing changes to the code of conduct:

CRAs should … establish policies and procedures for reviewing the past work of analysts that leave the employ of the CRA

The actual report states:

A CRA should establish policies and procedures for reviewing the past work of analysts that leave the employ of the CRA and join an issuer that the analyst has rated, or a financial firm with which an analyst has had significant dealings as an
employee of the CRA.

Sauce for the goose is most emphatically not sauce for the gander, is it?

Another howler from IOSCO’s press release is:

CRAs should … to discourage “ratings shopping,” disclose in their rating announcements whether the issuer of a structured finance product has informed it that it is publicly disclosing all relevant information about the product being rated;

Now, you’ll never hear me complain about too much disclosure, so I don’t have any major problems with this one … but I’d like to hear a discussion of just how well the philosophy behind this recommendation ties in with Regulation FD and National Policy 51-201.

Somewhat to my surprise, their actual report manages to come up with a sensible comment about the relationship between credit quality, liquidity and price (emphasis added):

The subprime market turmoil has also highlighted another common misperception that credit risk is the same as liquidity risk. Historically, securities receiving the highest credit ratings (for example, AAA or Aaa) were also very liquid – regardless of market events, there could almost always be found a buyer and a seller for such securities, even if not necessarily at the most favorable prices. Likewise, prices for the most highly rated securities historically have not been very volatile when compared with lower-rated securities. Indeed, in some jurisdictions regulations regarding capital adequacy requirements for financial firms implicitly assume that debt securities with high credit ratings are both very liquid and experience low volatility. However, the links between low default rates, low volatility and high liquidity are not logical necessities. Particularly with respect to certain highly-rated, though thinly-traded subprime RMBSs and CDOs, a high credit rating has not been indicative of high liquidity and low market volatility.

The credit crunch was largely just another episode of animal spirits and irrational exuberance. There are certainly some relatively innocent victims – those unable to get a mortgage, for instance, or who have to refinance as usurious rates – but really, no more or less unpleasant than any other episode. I graduated from university during a recession. Life’s unfair. Get used it to it.

To the extent that serious harm was done, it was largely the product of regulation. Regulators in many cases did not impose a rational cap on the Assets to Capital Multiple for many banks; guarantees (both explicit and implicit) for off-balance sheet instruments were not charged against capital at a high enough rate (one example is money market funds, not just SIVs); concentration risk was not charged to capital (at least, not sufficiently) and big changes in capital requirements upon credit downgrade fostered cliff risk and crowded trades. It also strikes me that capital requirements on debt could be adjusted by issue size (as an objective, albeit sometimes incorrect, proxy for liquidity) … there is clearly a difference between US Treasuries, where investors want a minimum $20-billion issue size and a tranche of RMBS with perhaps $300-million issued.

But the credit raters are a convenient target.

This entry was posted on Wednesday, May 28th, 2008 at 1:03 pm and is filed under Regulation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.