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| R Ravimohan: Setting the ratings record straight |
| R Ravimohan / New Delhi Dec 08, 2008, 00:22 IST |
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Just a fraction of firms with good ratings default, showing our methodology is quite robust. Getting firms to pay for their ratings does have a potential conflict of interest, but since we can then give the ratings out free to everyone, this increases transparency, says R Ravimohan
There has been much debate over the past year about the role and performance of credit ratings firms — yet despite the mass of information that ratings firms make available to the market, much of this discussion remains confused.
S&P appreciates the seriousness of the current dislocation in the capital markets, and we recognise that many of the forecasts we used in our ratings analysis of certain structured finance securities have not been borne out. We have actively sought, listened to, and reflected on the many comments and concerns that have been expressed in the markets, and are taking steps both to enhance our ratings process and to provide better and more information to investors. In that spirit, I would like to share some insights into the role and performance of our ratings.
Firstly, the meaning of a credit rating is not always well-understood. A Standard & Poor’s rating is, very simply, an opinion about creditworthiness, most often expressed as the relative likelihood of a future default.
Importantly, ratings are not recommendations to buy, sell or hold a particular security. They simply provide one tool for investors to use in assessing credit quality. They are one of many factors that investors may consider when making an investment, and there are a number of factors not addressed by ratings that can and do influence the market performance of a security.
Our ratings are based on the facts available to us at the time our opinions are formed. They are designed to be relatively stable — certainly more so than the market price of bonds or credit default swaps, which are highly volatile and heavily influenced by investor sentiment, liquidity and other variables. However, our ratings opinions can and do change over time as our views of the fundamental creditworthiness of a borrower or debt security evolve.
Like other major ratings agencies, Standard & Poor’s receives fees from the issuers it rates. This issuer-pays business model was introduced around 40 years ago in response to market demand. It has an important advantage over other business models in that it enables us to make our ratings opinions freely available to the market as a whole in real time. That in turn enhances the transparency and public scrutiny of what we do.
We — and the market — are well aware that this business model brings with it potential conflicts of interest: What matters to users of ratings is how we manage these conflicts. Standard & Poor’s has well-established policies and procedures to protect the integrity of our rating process. For example, ratings are assigned by committees, not by individual analysts. Our analysts are prohibited from negotiating fees and engaging in other commercial activities. And we specifically structure our analysts’ compensation so that it is not dependent on the fees related to the ratings they assign.
Above all, our reputation and integrity are our most valuable long-term assets, making it self-defeating for Standard & Poor’s to provide anything other than fair and independent ratings opinions. Our policy of making our ratings criteria freely available means that if we were to deviate from that criteria for a particular issuer, the market would readily know it and our ratings would quickly lose credibility.
Moving to a subscription (“investor pays”) business model is not a panacea. It would severely limit transparency and constrict the dissemination of ratings, as access would necessarily be expensive and exclusive to subscribers. It would result in less information in the market and remove an important check on ratings quality — the constant scrutiny of a broad and diverse market. It would also create its own set of conflicts: just as issuers would prefer higher ratings in order to lower their cost of capital, investors (all things being equal) generally want lower ratings in order to increase their yield.
Some have suggested switching to a state-controlled, public sector rating agency model. However, this model has its own conflicts: government is a powerful interest and may have its own view on what is an appropriate credit rating or an appropriate way of assessing credit quality.
Our view is that competition among ratings agencies with different business models is a good thing — there are now, for instance, 10 rating agencies in the US registered and regulated by the SEC, double the level of two years ago. What really matters, though, is how investors and other market participants view the independence, quality and credibility of ratings. Without acceptance in the market, new rating agencies will inevitably struggle to make an impact.
Finally, discussion about the track record of ratings agencies is often based on anecdote rather than analysis. In fact, a significant amount of information about the empirical performance of ratings is readily measured and monitored by the market (and by regulators) and is freely available in the form of the default and transition studies we publish. These studies show the detailed correlation over time between ratings and defaults.
They demonstrate that the long-term track record of our ratings as opinions regarding creditworthiness has long been — and remains — excellent. Over the last 30 years, the average five-year default rate for companies rated “investment grade” (generally considered by the market to be BBB — and above) is around 1.2 per cent and for speculative grade companies it is over 20 per cent. The default rates for structured finance securities over this period are broadly comparable.
Moreover, while there have been significant downgrades of ratings in certain recent classes of structured security related to the US mortgage market, relatively little of this debt (under two per cent of the original issuance value of US housing market-related securities rated by Standard & Poor’s since 2005) has actually defaulted — and defaults are the focus of our ratings.
Looking specifically at our AAA ratings, it is important to note that while the market valuation of many AAA structured securities has fallen heavily, very few have as yet defaulted. Of the almost 30,000 AAA ratings issued by S&P on structured securities since 1978, only 0.3 per cent have ever defaulted — broadly the same historic default rate as for AAA corporate bonds.
Nonetheless, we have acknowledged that many of the forecasts we used in our analysis of recent US subprime-related securities have not been borne out. Like others, we did not anticipate the sheer scale of deterioration in the US housing and mortgage markets. As a result, the performance of many of our ratings of recent US mortgage securities and related CDOs is worse than has been the case historically.
We are learning from this experience and are committed to continuously improving what we do. We have embarked on a wide ranging set of actions to further strengthen the ratings process and improve our transparency. Measures include rotating analysts, establishing an independent Ombudsman, increasing our surveillance staff and providing more information to investors about our rating assumptions and stress tests (details on www.spnewactions.com).
Ultimately, we think we will continue to be judged on the track record of our credit ratings as opinions of creditworthiness. It is this track record, supported by our values of independence, objectivity and analytical rigour, that supports the role we continue to play in the global capital markets.
The author is Managing Director & Region Head, Standard & Poor’s South & Southeast Asia
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