Insights from Henley Business School
Quis Custodiet? Rating Agencies, Real Estate Debt and the Credit Crunch
In the current financial turmoil, as the sub-prime crisis gave way to the credit crunch and fears of world recession, it was inevitable that there would be a search for guilty parties. Attention turned first to banking practices and then to the creation of, and reliance on, "complex financial products". From this, mortgage backed securitisation has been portrayed as inherently wrong, promoting demands for regulation orprohibition and calls for a return to traditional, conservative, approaches to property investment. But is the MBS model really fundamentally wrong?
Mortgage backed securitisation has many benefits in "normal" markets. By pooling loans and selling securities into capital markets, risk is spread widely, providing investors with diversified exposure to real estate debt. The tranche structure creates appropriate securities for investors with different appetites for risk. Banks access new sources of capital and obtain direct market signals of risk – yields in the CMBS market providing real-time information on property sentiment. These represent substantial efficiency gains, creating competition, limiting non-price rationing and unreasonable lending terms across the cycle.
Efficiency gains, though, rest critically on good information and risk assessment. Loan originators must assess the risk of individual loans, setting conditions and interest rates reflecting the probability of loss given default. Securitisation works precisely because investors obtain diversification and do not face high information costs. This relies on the securitisation process being transparent and on readily available risk-return signals. It is here that the key role of credit rating agencies becomes apparent. By providing accessible, understandable indicators of the characteristics of MBS tranches, rating agencies allow investors to select and manage portfolios of securities at low cost.
Flaws in the system
With hindsight, flaws in this system are evident. If rating agencies systematically misidentify risk, and if investors make portfolio decisions relying on those ratings, then the market becomes extremely vulnerable to shocks. The volume of issuance of structured products and, critically, growing product complexity created major pressures for the agencies. With no performance data on the new securities and provision of inaccurate (even fraudulent) information on underlying assets, the complexities and time pressures contributed to ratings models that failed to account for inherent downside risks and high correlations between assets that might default if – when - extreme shocks occurred. Sometimes this was compounded by modelling error (as with CPDOs) but mispricing of risk seems endemic.
Problems with rating models were compounded by structural issues. With issuers paying for ratings, major conflicts of interest exist. First, there is pressure on agencies to provide more favourable ratings for clients to capture market share. Second, agencies simultaneously advise clients on the structuring of deals and rate those deals. There are voluntary codes of practice, Chinese walls, intended to keep processes separate, but moral hazard exists. In 2008, the SEC concluded that rating agencies had failed to manage conflicts of interest adequately. Many post-credit crunch reform proposals have focussed on this aspect. Thus, EU proposals seek compulsory registration, improved corporate governance, external oversight, inspection and transparency reviews.
However, more fundamental problems must be confronted. Ratings are hard wired into the architecture of global finance, embedded in the regulatory system, in Basel regulations that were intended to prevent global meltdown. "Institutionally acceptable" financial products are defined by their ratings. Issuers must create assets which achieve credit ratings to meet regulatory and investment hurdles. From their creation, CMBS structuring and rating have been locked together – structuring is about rating. Financial institutions bought CMBS portfolios because of their rating, ratings underscored their use as collateral in inter-bank borrowing. The importance of rating in regulation and investment helped preserve the dominant position of the big three agencies. The EU proposals do nothing to counteract this, although the SEC does seem to be moving away from regulatory reliance.
Restoring confidence
What will restore confidence in rating? Greater oversight, improved governance and transparency address problems of conflicts of interest but do not address the structural issues contributing to past failures. Over-rigid regulation stifles financial innovation and hardly engenders efficiency in credit markets however seductive a back-to-basics simplification of financial structures might seem. Furthermore, will regulatory bodies have the necessary skill base to audit rating? Enforcing greater competition and reducing dependence on the big three agencies seems appealing: but part of the cause of mispricing of risk was competitive pressures amongst the main players.
Conflict of interest and client pressure arising from issuers paying for ratings could be solved by returning to investor subscription services. New problems arise, however. With so many investors in credit products, free rider problems emerge – why pay when the rating will quickly become public? Second, issuer have less incentive to provide full, accurate information. A better alternative might be to create a pool of independent but "official" agencies. Listing authorities could require issuers to supply data and pay levies on issues to fund the pool. The listing authority would then draw an agency from the pool to assess a particular issue, creating arms' length ratings while maintaining valuable public information. Agencies could still provide consultancy services to issuers. Such a system, though, demands more than three ratings agencies to be effective and must allow for a re-rating process.
Reducing or removing rating from regulatory structures has many merits, reintroducing a caveat emptor imperative for investors, who can no longer hide behind simple ratings-based rules. That would force rating agencies to demonstrate added value, that the ratings process produces price sensitive information. Investors will demand ratings, issuers will commission ratings only if they are of benefit, not simply because they fit convenient Basel or investment mandate boxes.
To demonstrate that added value, independent research is needed. Do agencies' initial ratings accurately predict losses given default? Does this result hold for different types of security, different market environments? The paucity of rigorous research on CMBS rating partly relates to data availability and openness. Alongside creation of a system that directly addresses conflicts of interest and moral hazard issues and the regulatory pressures of the current process should be a drive to encourage research and performance monitoring of the outcomes and effectiveness of rating.
Independent rating of debt vehicles has a vital role to play in the efficient operation of financial markets. The current system has proved ineffective in price risk correctly. Any new structure must deal with structural flaws in the existing system without blocking information flows or introducing bureaucratic structures that are inflexible and stifle innovation– a balancing act that demands careful thought, not knee-jerk reactions.
A version of this article appeared in the January 2009 issue of IPE Real Estate.