Friday, March 15, 2013

Are Credit Ratings Opinions?

The Justice Department's lawsuit against S&P made us reconsider whether the ratings provided by S&P were "opinions."

Let's quickly look at the concept of an opinion: one often relates the word "opinion" to a judgment (which may be factually supported) but may not be "provable."  A fact, however, is closer to being provable.

Of course, the rating agencies have long argued that their ratings are opinions, but there's probably more to it than that.

At the very beginning, many rating agencies have the ability (and they exercise it) to assign a rating of "D" to defaulted issuers or assets.  Many (but perhaps not all) issuer or asset defaults, relative to their defined terms, are directly provable - in other words, at least certain ratings may be more fact, and less opinion.

Now let's dig deeper into the DoJ's argument.  One core argument alleged throughout the complaint was that S&P maneuvered its models/methodology to achieve the rating levels desired by the structuring bankers (the issuers).
"As set forth in detail … S&P's competition for ratings business, that is, its desire to maintain and increase market share and profits, and its resulting desire to maintain its relationships with issuers who drove its ratings business, improperly influenced S&P to favor issuers in its ratings of RMBS and CDOs. In particular, as alleged in detail … to maintain and increase its market share and profits, S&P limited, adjusted, and delayed updates to the ratings criteria and analytical models S&P used to assess the credit risks posed by RMBS and CDO tranches, thereby weakening those criteria and models from what S&P analysts believed was necessary to make them more accurate."
The argument could therefore be that the resulting rating wasn't the "opinion" formed as part of the ratings process: the required rating, known upfront, caused the determination as to which ratings process/model to apply.  In such a case, the rating would be the fact, and the process (to be used) is the judgment.

In other words, an argument may be that the resulting ratings were not the result of the ratings process.  The ratings processes used were the result of the rating required!  

(Think of this relative to the structuring process itself, one of the goals of which is to achieve a certain rating.  Thus it may be inferred -- if the DOJ's allegations hold true -- that both the banks and S&P were playing the role of engineering their analyses in such a way as to achieve the desired rating.)

Monday, March 4, 2013

Are the Rating Agencies in Sync?

This morning's Financial Times brought with it another wonderful article by Arturo Cifuentes.  Much of his commentary on ratings reform is not new - but it is important that we be reminded of the distance we have yet to travel.

We're going to examine one element of his piece, an element he has brought up before: the rather peculiar situation of credit rating agencies coming to the same conclusions (i.e., equivalent, mapped ratings) in the structured finance arena, despite the application of different methods and proprietary data (and different rating scales, and having different ratings meanings, but Prof. Cifuentes doesn't mention these here).

Digging a little deeper, we notice similar behavior in other spaces too.  In corporate finance space, Dell Corporation - the maker of laptop computers, among other things - had not had its rating visited by any of the "Big Three" credit rating agencies since 2007.  On February 5, 2013, all three rating agencies downgraded Dell. (See screenshots courtesy of Bloomberg LP.)

Equally interesting, the last time S&P and Fitch analyzed Dell was within a week of one another in August 2007.

Late last month, the Economist ran an article that tried to describe how the rating agencies rate sovereign debt.  What the article did do was show just how similar their opinions are of sovereign countries.

We did a back of the envelope analysis to establish whether they tend to share the same ways of looking at sovereign countries, by converting the ratings to a simple comparable scale, and measuring correlation using the excel function. (Moody's Aaa and S&P or Fitch AAA were all converted to a "21"; Moody's Aa1 and S&P/Fitch's AA+ were converted to a "20" and so on.)

We found the correlation to be extraordinary:

Of course, we're not saying the rating agencies always agree.  We covered in 2011 how in the realm of seasoned structured finance deals, they vary widely in their opinions.  But the concept here may be that there is less pressure to agree once the deal gets done or for securities over which the scrutiny is limited. When they're competing, however, they seem increasingly to agree.