/58

R&D

The financial crisis poured discredit on to rating agencies that has yet to be dispelled. Moves are now underway to restore their reputation as essential and reliable tools. Jerome Fons, executive vice-president at Kroll Bond Ratings, writes

Rebuild the trust

I
magine a football match where the fans stream out of the stadium while the game is still in progress because they dont trust the referee or the timekeeper. It sounds unlikely, but the analogy can apply to what is happening in the structured finance market. In this case, the fans are the buyers of structured finance securities and the referee and timekeeper are the rating agencies. To bring the fans back into the stadium, we have to restore trust to the system. There are a number of efforts to do just this. Some solutions will come from public policymakers in the form of new legislation and regulations. Others will come from the private sector, such as new competitors as well as a review of how ratings are used in making investment decisions. Many have argued that credit ratings are an anachronism and have outlived their usefulness. Yet we believe there will continue to be a demand for accurate credit ratings. Many fixed-income fund managers lack the resources necessary to analyse the thousands of obligations from which they can choose to invest. They need a reliable source of unbiased, competent analysis. Historically, the credit rating industry was able to meet these needs; until the late 1990s, the major bond rating firms had established an enviable track record of signalling credit risk. The past decade, however, has shed doubt on both the business of ratings and the craft of credit analysis. We believe the future of the bond ratings business will differ from the

Jerome Fons, executive vice-president, Kroll Bond Ratings

the markit magazine Autumn 2010

R&D

/59

Jerome Fons Rsum

2007 - Present 1990 - 2007 1989 1988 - 1989 1985 - 1987 1985 1979 Kroll Bond Rating Agency, executive vice-president Moodys Investors Service, managing director, credit policy Chemical Bank, economic advisor Federal Reserve Bank of New York, economist Federal Reserve Bank of Cleveland, economist University of California, San Diego. PhD, economics San Diego State University, BA, economics

current model in terms of the depth of analytics offered, the transparency of analytical methods, rating agency governance and an emphasis on surveillance post-issuance. The future of the ratings business depends on these changes, which are further entrenched with the passing of the Dodd-Frank bill earlier this summer, which we will go into later in this article.

Enhanced analytics
Investors deserve an independent review of the asset originator, as well as the creditworthiness of the underlying collateral. Historically, the major Nationally Recognized Statistical Rating Organizations (NRSROs) have not performed due diligence and they emphasised that their role is not that of an auditor. They have never described their work as rising to the level of due diligence, perhaps to avoid legal liability, although this is just speculation. However, due diligence in its most stringent definition is required. One proposed model is that the NRSROs have the issuer or underwriter hire a firm to undertake such due diligence. Under this plan, the NRSRO will help scope out the range of due diligence work and will review the results, but it will not take responsibility for the work product. In our opinion, this is not sufficient. As the firm providing the rating, it is the rating agencys responsibility to perform or contract out any due diligence work. As a result, the ratings firm must take responsibility for the quality of the information used to generate ratings. If the rating firm cannot uncover sufficient information, then it has an obligation not to rate the security. In the residential mortgage-backed security (RMBS) sector, due diligence

should include a sampling of loan files, specifically looking at source documents such as pay stubs, tax returns, credit reports and bank statements. Diligence should involve an independent analysis of the market value of specific homes to determine the veracity of the loan-to-value (LTV) ratio. The resultant information will be more detailed and more robust than simply relying on a loan tape. This enhanced approach will be a key distinction between the successful rating firm and those whose work cannot be trusted.

Transparency
Even after the crisis, after all the downgrades and failed analyses, there are still aspects of ratings models that are not fully explained. Such black box

ratings methodologies need to be clarified, so that an informed investor can verify the quality of the ratings process. Rating methodologies must be supported by relevant research that will enable investors to understand all aspects. At the same time, issuers must improve disclosure of structural features and underlying asset characteristics and performance. In order for investors to gauge the relative quality of the ratings process, they need to have access to the information supporting the rating. For RMBS, this means up-todate loan level performance data. The communication of rating system objectives and performance is an important aspect of transparency that has been largely absent to date. Rating agencies need to outline exactly what it is they purport to measure and reveal their track record at meeting these objectives. An emphasis on rating accuracy is paramount. This means ratings must reflect our true assessment of credit risk at each point in time. They must do the best job possible of separating ex-ante

Investors deserve an independent review of the asset originator, as well as the creditworthiness of the underlying collateral.
Autumn 2010 the markit magazine

/60
$ Billions 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

R&D

Global Private-Label Securitisation Issuance

ABCP CDO^2 CDO ABS MBS

issuers and obligations at risk of default from those that are not at risk. Ex-post performance should be shared so that market participants can determine the extent to which the rating firm meets its stated goals.

Governance
It can be argued that the failure of the major rating firms prior to and during the recent credit crisis was due not to faulty models or analysis but to poor governance. Incentives were misaligned to the point where managers and analysts focused more on market share and revenue than on protecting investors. We see governance and compliance as the cornerstones upon which to build investors trust in the ratings process. As such, governance structures must be enhanced, such as an investor advisory board made up of a consortium of fixed-income investors. Such a board should not be a generic oversight body, but rather, it should have a say in the rating firms incentive structure, up to and including employee compensation. Additionally, new policies must be put in place that guard against some of the practices that led to the recent problems at the incumbent rating agencies. Rating shopping, for instance, should not be allowed. If a firm begins the rating process, it should publish the rating, whether asked to or not. Issuers should not be allowed, after seeing the rating analysis, to decide whether or not to use the issued rating on a particular deal.

2000

2001

2002

2003

2004 Year

2005

2006

2007

2008

2009* *end June

Source: IMF

Post-issuance surveillance
During the heyday of structured finance issuance, the major rating firms were so overwhelmed with meeting demand for ratings on new issuance that they neglected the ratings on seasoned securities. This was in part due to the business incentives of the structured finance market: rating fees are paid upfront, with negligible, if any, surveillance fees involved. A rating firm emphasising accuracy must devote sufficient resources to

Rating shopping, for instance, should not be allowed. If a firm begins the rating process, it should publish the rating, whether asked to or not.
the markit magazine Autumn 2010

R&D

/61

the surveillance process. This includes monitoring underlying assets and incorporating any changes into cash flow projections. Where warranted, ratings must be adjusted to reflect developments affecting the performance of rated securities. A feedback loop incorporating ongoing research will be the foundation of future rating methodologies. As markets change, analytical models and ratings must reflect those changes. Rigorous post-issuance surveillance is an important aspect of this research/ feedback loop and one that was noticeably missing from the last RMBS crisis. The focus on research and surveillance will provide the necessary tools to arm investors with more accurate ratings and analysis. These elements are essential in order to create a functioning, trustworthy rating agency. Therefore, we were not surprised when the legislature passed financial reform based on the same principles.

...there may be certain rating firms that opt out of the structured ratings business. While this could initially create uncertainty, it might ultimately create a narrower, more focused group of agencies willing to stand behind the work they produce.

A new ratings regime

On July 21 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. This legislation makes a number of changes to existing rating agency regulations and creates new authority for the US Securities and Exchange Commission (SEC) to regulate NRSROs. The acts focus is on reducing or managing conflicts of interest and improving disclosure. Many of the new rules are processorientated and rely heavily on a beefedup compliance function. The new disclosure requirements mandate that NRSROs publicly indicate the assumptions used to assign a rating and provide a description of the data used and any reliance on third-party due diligence. Particularly for structured securities, if an external due diligence firm is used, the NRSRO must make available the findings and conclusions of the due diligence firm, along with written certifications attesting to the completion of the described work.

We support taking an active role in the due diligence efforts. This includes scoping out the work to be performed and, to the extent we rely on specialised, independent, due diligence firms, being responsible for selecting and managing their work product. The Dodd-Frank bill removes the exemption NRSROs enjoyed to the SECs Regulation FD, or fair disclosure. Previously, a rated firm could provide confidential, or non-public, information to an NRSRO and not be obliged to disclose that information broadly. That is no longer the case. Thus, it will fall on the raters to rely less on representations made by issuers and rely more on their own sources of information. And to the extent a rating firm is able to uncover non-public information, the firm should, where appropriate, incorporate this into its ratings. One of the most controversial parts of the new act is the lowering of the liability shield for rating agencies. The major rating firms have each indicated that they will not provide their consent to be named as experts in certain securities filings. Initially, this threw a spanner in the works for the asset-backed markets

until the US SEC stepped in and offered a six-month waiver to the asset-backed disclosure requirements. What the final fix will look like is anybodys guess, but there may be certain rating firms that opt out of the structured ratings business. While this could initially create uncertainty, it might ultimately create a narrower, more focused group of agencies willing to stand behind the work they produce. Firms should have in place and should follow procedures that minimise exposure to liability by reducing the likelihood of inaccurate ratings. As long as they follow their policies and meet compliance guidelines, the rating firms should be able to avoid devastating legal (or criminal) sanctions. The economy is still recovering from the turmoil of the past few years. As the market acclimatises to a new normal, the credit rating business must be a responsible partner to the investment community by providing quality ratings supported by sound methods. Trustworthy credit ratings will lay the foundation for the rebuilding of the economy. A commitment to accuracy and integrity is the only way to bring the fans back into the stadium.
Autumn 2010 the markit magazine