Calls for credit rating agency reform grow

A task force established by the International Organization of Securities Commissions (IOSCO) to study the sub-prime mortgage crisis announced on Tuesday that it wants to see significant reforms in the way international credit rating agencies conduct business, something the task force believes will help prevent future credit crises.

The Task Force on the Subprime Crisis, launched by IOSCO at a November meeting in Tokyo, wants to revise the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies to reduce conflicts of interest and increase transparency in the industry.

Credit rating agencies have come under heavy fire for failing to contain the sub-prime crisis by not doing an adequate job of identifying the default risks associated with structured investment products, such as collateralized debt obligations (CDOs) and asset-backed commercial paper (ABCP). Further scrutiny has revealed many of these products received high credit ratings despite having high levels of exposure to risky U.S. sub-prime loan mortgages.

Some of the task force’s preliminary proposals, which will likely be included in a consultation paper due in March, include improving the disclosure of the assumptions underlying the individual ratings for structured finance transactions and improving the quality of information used to support a credible rating.

To remove conflict of interest, the task force also wants to prohibit rating agencies from offering advice on the design of structured products, which an agency also rates.

The CFA Institute is firmly in IOSCO’s corner.

“As we discussed the sub-prime market meltdown with our members from around the world, the call for credit rating agencies to distinguish structured product ratings from corporate ratings and improve their processes was clear,” said James Allen, CFA and director of capital markets policy group for the CFA Institute. “We support IOSCO’s code of conduct for CRAs as a globally accepted industry standard and suggest improvements to the code to enhance investor confidence.”

The CFA Institute’s additional recommendations include creating a separate ratings category and nomenclature that distinguishes structured product ratings from both corporate and commercial paper ratings.

Allen says the yield differential between corporate debt and the debt in the structured products was significant, and that experienced analysts understood there had to be a difference with the underlying risk, but that distinction was not officially recognized.

“Our reason for calling for a change in the terminology is that things were rated the same, one being corporate and one being structured. The different groups carried significantly different yields in the market,” he says. “Sophisticated investors understood that, but others may not have understood that as much. Part of the idea of using different terminology is to reduce that confusion.”

Ideally, if two different categories are created, it would spur tougher due diligence on the part of investors researching the underlying assets, Allen says. Due diligence could be further motivated by revising or even eliminating the usage of the term “investment grade.”

Allen says there has been a misconception by many investors that investment grade means safe, which it does not. It means that the investment has met minimum standards for institutional funds to invest in it. It doesn’t mean they don’t carry a high level of risk.

“Our point was that term can and has caused confusion,” he says. “Investors would still have to recognize that investments still have certain cut-offs [making them ineligible for fund investment] and can be rated below this.”

The CFA Institute would also like to see the prohibition of a practice called “notching” whereby a rating agency issues a rating on an entity or structure that was not sought by the issuer. It would also like to see IOSCO’s code of conduct adopted as a claim to compliance and an executive-level compliance officer put in place to enforce the code.

In addition, the CFA Institute wants credit rating agencies to refrain from rating new structured products until their statistical data is “sufficiently robust” to produce a rating that can be defended.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(02/06/08)

Mark Noble