S&P proposes overhaul of ratings process

As the chorus of voices for credit rating reform grows, one of the world’s largest rating agencies, Standard & Poor’s, has announced it will overhaul its process.

“The ongoing transformation of the financial markets requires us to continue to bring more innovative thinking, greater resources and improved analytics to the ratings process,” says Deven Sharma, president of S&P. “By further enhancing independence, strengthening the ratings process and increasing transparency, the actions we are taking will serve the public interest by building greater confidence in credit ratings and supporting the efficient operation of the global credit markets.”

Credit rating agencies have borne the brunt of blame 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). Many of these products received high credit ratings despite having high levels of exposure to risky U.S. sub-prime loan mortgages.

Critics have pointed to a number of fundamental flaws with credit rating agencies, particularly the lack of transparency in their ratings process and potential conflict of interest.

Related Stories

Calls for credit rating agency reform grow

S&P’s proposed overhaul is divided into four core areas: governance, analytics, information and education.

Probably the most drastic changes are being made in analytics, where the company says it will undertake a consultation process to determine if its ratings should include factors apart from default risk, such as liquidity, volatility, market correlation and recovery.

This would be a major development since a great deal of the problems associated with structured products, like ABCP, concern liquidity and market value. Providers of third-party ABCP ran into most of their trouble by not being able to roll over enough ABCP to earn a steady cash flow, despite assurances the default risk was low. It should be noted S&P did not rate third-party Canadian ABCP.

“Recent events show that some investors infer information about the price stability and liquidity of rated instruments that the rating was not intended to denote,” S&P wrote in the 10-page proposal. “S&P ratings don’t guarantee the availability of a market to trade at a fair price. Therefore, we are examining ways that we can provide insight into non-default risks such as liquidity, volatility, valuation and recovery, while maintaining clarity about the role of credit ratings.”

S&P says it will also improve the surveillance of structured securities by enhancing the data and models utilized in surveillance and by increasing the size of its surveillance staff. In addition, S&P will implement more rigorous training requirements for its analysts, including increasing the minimum 20 hours of training required by analysts each year. The company says it is also partnering with an academic institution to develop an analyst certification program.

Among the proposals for improving information is to develop a standard research format for “what if” scenarios, which would cover the ratings implications of changes in the underlying assumptions upon which the ratings are based. S&P says it will offer tools to investors along with relevant information to allow them to develop and conduct their own stress scenarios based on their own assumptions.

Another proposal S&P is toying with is ways to better explain the comparability of ratings across asset classes, such as structured assets versus corporate or government assets. This is a proposal that has been strongly advocated by market observers, most recently the CFA Institute.

Proponents of greater categorization say the yield differential on structured debt versus plain vanilla debt, like government and corporate bonds, is proof positive that the underlying assets require different ratings processes.

“S&P has conducted research on the comparability of its ratings across different asset classes, with a focus on consistency in default, transition and stability. S&P will publish these research findings, which will help clarify the ways in which our ratings are similar across asset classes [as predictors of default],” S&P said in a statement. “While S&P ratings have generally performed consistently across asset classes in terms of default experience, recent events have highlighted the need for more research and discussion with the market about possible ways to provide even greater clarity.”

On the governance front, S&P says it will implement further checks and balances to ensure the integrity of its ratings system. The company will appoint an ombudsman, to whom market participants can raise concerns about potential conflicts of interest and integrity. The ombudsman will have the authority to escalate all unresolved matters, as necessary, to the CEO of corporate parent McGraw-Hill and the audit committee of the board of directors.

S&P also says it will engage an external consultant to periodically conduct independent reviews of its ratings compliance and governance processes. The opinion of the external firm will be made public and presented to S&P’s risk assessment committee, McGraw-Hill corporate management and the audit committee of the McGraw-Hill board.

S&P’s proposed overhaul comes just two days after the International Organization of Securities Commissions released its own set of proposed reforms for the world’s rating agencies, which would require greater transparency and accountability for ratings processes.

A spokesperson for S&P says the IOSCO proposal was not the reason for announcing its own set of reforms, but the firm is willing to consider anything to improve the industry.

“We are willing to do anything we need to do to improve the business,” the spokesman says. “At this point, we think we have taken a positive step forward. It’s a good step in increasing transparency in the market.”

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

(02/07/08)

Mark Noble