IMF Calls for New Credit Rating Scale

As reported today by Bloomberg:

The IMF, which is charged with promoting global economic stability and lends to financially distressed nations, blamed the crisis on “benign economic and financial conditions” which “weakened incentives to conduct due diligence on borrowers and counterparties.”The fund also said the methodology of credit-rating companies, some of which gave high ratings to subprime mortgage securities that have plummeted in value, needs to be examined. The complexity of many of these securities may have made it difficult for investors to assess their worth based on the assigned ratings.

“In the case of complex structured credit products, investors need to look behind the ratings,” the report said.

Regulators and investors will have to work together to strengthen financial markets to prevent a recurrence, and develop ways to improve the spread of accurate and timely information to help markets assess risk, the report said.

Parts of this report are available at the IMF site. In Chapter 1 they urge:

The need for a differentiated scale of credit ratings has
again been made apparent.

The fallout in the mortgage market has drawn attention to the role of credit ratings agencies in structured credit markets. Less sophisticated investors, who were content to delegate the risk assessment of their positions to the credit ratings agencies, were negatively surprised by the intensity of downgrades. Previous GFSRs have pointed out that structured credit products are likely to suffer more severe, multiple-notch downgrades relative to the typically smoother downgrade paths of corporate bonds (IMF, 2006). The experience of the past year has underscored the need for further efforts to inform investors of these risks, but better still would be the introduction by ratings agencies of a more differentiated scale for structured credit products. For example, a special rating scale for structured credits could be introduced to highlight to investors that they should expect a higher speed of migration between ratings than on a traditional corporate bond.

The section (page 37 of the PDF) ends with some sound advice for institutional investors; sadly, it does not advocate that institutional investors who bought CDOs without understanding them seek retraining as ditch diggers. The closest they get to advocating this urgently needed market reform is elsewhere in the document:

Finally, credit ratings evaluate only default risk, and not market or liquidity risks, and this seems to have been underappreciated by many investors.

Which isn’t really very close, is it? Ah, well, perhaps someday.

Update: Accrued Interest has some explanations and suggestions for the CDO market.

2 Responses to “IMF Calls for New Credit Rating Scale”

  1. […] Accrued Interest has posted a fascinating discourse on CDOs and I am very hopeful that the comments will help me understand what all the fuss is about. I’ve also referenced this post on my post about the IMF’s recommendation. […]

  2. […] I will be fascinated to see how this unfolds. There is no doubt that sub-prime is resulting in a big heap of losses; but it is my contention that market values have grossly over-compensated for these losses. Readers with good memories will remember the IMF Report which I have discussed previously: Spreads have since widened across the capital structure, especially on lower-rated ABS and ABS CDO tranches, but also on AAA-rated senior tranches (Figure 1.9). Implied losses based on these spreads total roughly $200 billion, exceeding the high end of estimated realized losses by roughly $30 billion—an indication that market uncertainty and liquidity concerns may have pushed down prices further than warranted by fundamentals (Box 1.1). While many structured credit products were bought under the assumption that they would be held to maturity, those market participants who mark their securities to market have been (and will continue to be) forced to recognize much higher losses than those who do not mark their portfolios to market. So far, actual cash fl ow losses have been relatively small, suggesting that many highly rated structured credit products may have limited losses if held to maturity. […]

Leave a Reply

You must be logged in to post a comment.