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Subprime ratings for rating agencies

Published: August 16 2007 21:19 | Last updated: August 16 2007 21:19

It is almost a ritual. At some point in any credit crunch the ratings agencies – Moody’s, Fitch and Standard & Poor’s – are criticised for giving the problem debts high ratings in the first place and then for being too slow to downgrade. The ratings they gave to bonds backed by US subprime mortgages had problems but wholesale regulatory intervention does not make sense.

The European Commission wants to know why some bonds backed by subprime got high ratings and why others were not downgraded sooner. In the US, there are political rumblings in Congress as well.

In part, this is due to a misunderstanding of what credit ratings agencies do. They do not predict when the price of a bond will go down, or recommend one AAA credit over another. All they assess is a borrower’s financial strength and the probability they will repay, even in times of financial stress. Any professional investor who buys bonds using nothing but a credit rating should be sacked.

In part, however, repeated government scrutiny reflects the ratings agencies’ fundamental conflict of interest. They provide ratings for investors, but are paid by the banks and corporations that sponsor and issue bonds. Issuers want high credit ratings and they will shop around the agencies to find which will give them the highest marks.

This conflict is well-known, long-standing and hard to do anything about. A full solution, severing the financial links between issuers and agencies, is probably beyond either the commission or Congress. Their inquiries should focus instead on specific conflicts of interest around financial innovations such as securitised subprime debt.

Ratings agencies have been willing to give AAA ratings to the least risky slices of debt cut from pools of subprime mortgages. That helps banks to sell them but also gives the misleading impression that the risks are the same as those of an AAA-rated Treasury bond. The agencies need to find ways to make the difference clearer.

Subprime is a new market and there is little history on how such borrowers fare during downturns; most of the data that are available have been supplied to ratings agencies by the very banks that want to sell bonds. Any inquiry should ask whether the data on subprime were robust enough to justify the ratings, whether caveats were issued and whether banks passed on accurate and sufficient information.

The ratings agencies seem to have been overoptimistic about subprime securities. But some of such borrowers will always default and they cannot be blamed for that.