Former rating agency worker: no fundamental changes have been made since the financial crisis hit

In a Guardian interview, a former rating agency worker expresses fear for the stability of the financial system by noting that there has been no fundamental change since the financial crisis hit.

Regular readers know there has been one change.  The prescriptive financial regulatory industry has grown by leaps and bounds.  Look at all the detailed regulations that are being churned out under Dodd-Frank.  By doing so, they have protected opacity across large areas of the financial system.

"I was on holiday in the runup to the collapse of Lehman Brothers, when the crisis exploded. I remember opening up the paper every day and going: 'Oh my god.' It was terrifying, absolutely terrifying. We came so close to a global meltdown. .... 

Now here we are four years later, and the most incredible thing has happened – we've learned nothing from the whole thing. Everybody pretends it's all OK. ... 

"If you had told people at the height of the crisis that four years later we'd have had no fundamental changes, nobody would have believed you. Such was the panic and fear. But there we are. We went from 'We nearly died from this' to 'We survived this'. 

It is a real testament to the power of the prescriptive financial regulatory industry that they were able to block the return of transparency to all the opaque corners of the financial system.  Instead, we have a bunch of one-off regulations that attempt to achieve what transparency would do.  


For example, we have issuers retaining an interest in structured finance securities.  The reasoning being that this will give the issuers an incentive to underwrite less toxic junk.

If there were true transparency into the underlying collateral, investors would not care whether the issuers retained an interest or not.  With true transparency that includes observable event based reporting, investors could assess the risk of the underlying collateral and know what they own.

If a deal includes high risk assets, the investor would demand a return that compensated them for the risk of the assets.

"Have you read Gillian Tett's Fool's Gold about the crisis? It was exactly like that. You had bankers who did not understand their own complex financial products but thought that they did, and then raters who took their word for it. And nothing has fundamentally changed.  

"As most people understand by now, lots of sub-prime mortgages were bundled by banks into financial products and sold on to investors. These believed they bought a very safe thing because the products had been rated triple A, which meant that there was only a 1% or so chance of a default. 

"When the crisis hit, it hit hard, reality kicked in and the rating agencies suddenly downgraded triple A products to junk status in a matter of days. I won't call it fraud; I will call it a 'desperate revision of history'. 

In the absence of transparency into the underlying collateral, investors turned to the rating agencies who  failed to inform the investors that they had no better access to information on the underlying collateral than did the investors.

This was not clarified until the fall of 2007.

"Overall, it was more incompetence than outright fraud. .... As far as the rating agencies were concerned, it was incompetence brought on by short-termist, bottom-line thinking by senior management who just wanted to make money. That meant rating as much as possible, as often as possible.... 

"When asked about the crisis, rating agencies use the defence that the bankers who designed those complex financial products did not understand them themselves. So how can rating agencies be blamed for not understanding them either**? 

"But you shouldn't just rely on the information given to you by the people whose product or company you are rating.... 

"With every new financial product, raters should be asking: have the products been tested properly? Are they modelled for all possible conditions, so boom as well as bust times? Do we even know what it does in every phase of the economic cycle? Do we know how the product is likely to evolve over time, how will it behave when it develops into a bubble?

Investors should be asking the same questions.  In addition, investors should not invest unless they are sure that there is transparency so that they have access to all the useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.

Former head of S&P structured finance: Ratings aren't meaningful or trusted

As reported by Bloomberg, the bottom line on credit ratings from David Jacob, the former head of structured finance at S&P is

“[Rating companies are] there because people have to have them, not because people believe in them,” ....  “Maybe retail investors do, that’s the unfortunate part, but I think institutional investors don’t.”... 

Jacob, hired four years ago to help restore confidence in S&P, says policy makers haven’t gone far enough to reduce reliance on the ratings companies, granted the authority by U.S. regulators 76 years ago to determine which borrowers deserve credit.....

“Ratings are not God’s holy work,” said Jacob, 56, a graduate of Queens College in New York with degrees in math and finance from New York University. “It’s a business. It’s a fine balance between trying to get a certain amount of market share versus losing your credibility.”...

It is a business that would change considerably if more transparency were brought into all the opaque corners of the financial markets.

With everyone having access to the same information, the rating firms would have to show they add value through their analysis.

“Moody’s is not going to detect some problem in advance and move a rating to warn the public,” said Fisher, whose firm manages about $44 billion. “Whether it’s a stock or a bond, the free market already did that. Moody’s goes along afterwards and effectively validates what the market’s already done.”... 

 The clear perception is that the rating companies are a lagging indicator at best.

S&P President Douglas Peterson said at a meeting of the Institute of International Finance in Copenhagen on June 6 that ratings companies help ensure that bond issuers provide “transparent information” under “strict standards of governance and control.”... 

Transparent information to whom?

Historically the rating companies model has been built not on public disclosures by the borrowers, but rather that the rating firms have access to information that is unavailable to other market participants.

Jacob joined S&P after managing commercial- and residential-mortgage bond groups at Nomura Holdings Inc. from 1993 to 2007. He said he sought to ensure that S&P analysts didn’t loosen standards at the request of bankers. The firm won less business in certain areas as a result. 

“We’ve swung back from where it was before when it felt more like the Wild West, but of course it puts a crimp on the business,” Jacob said in the interview last month. “It’s important for investors to watch to see if there’s a change and a shift in terms of trying to rebuild that market share.”....

The path to rebuilding market share is by loosening rating standards.  We saw how well that worked in structured finance leading up to the financial crisis.

Grading government bonds is outside ratings companies’ traditional areas of expertise, Jacob said. 

“You’re talking about politicians, you’re talking about legislators, you’re not talking about credit risk,” he said. “I don’t see how a rating agency has any better call on it than you or me or anybody else.”... 

Jacob said he is now considering working in financial regulation. 

One reform that would improve the quality of ratings would be to have all scores correspond to percentage chances of default, rather than the vague definitions now in use. S&P says its top rating means the issuer is “extremely strong,” while Aaa bonds are considered “highest quality” at Moody’s. 

“I was there three and a half years and I still don’t understand it,” Jacob said. “When people can use the same set of letters and mean entirely different things, then they become useless.”

Bottom line:  rating companies are another layer of opacity in the financial system.

Moody's bank credit rating downgrades highlight need for ultra transparency

A reported by the Telegraph, Moody's lowered the credit ratings on Britain's biggest banks.

This change in ratings highlights two lessons learned at the beginning of the financial crisis.

• Ratings lag what is actually occurring; and
• The market is still overly dependent on ratings.

Both of these lessons are addressed by requiring the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this information, rating firms have no excuse for not changing their ratings on a timely basis.

With this information, market participants can independently assess the risk of the banks and as a result there is no need to rely on the rating firms.

Britain's biggest banks, including Barclays, Lloyds and the Royal Bank of Scotland, have had their credit ratings slashed by Moody's as part of a worldwide review of bank credit ratings....

In a statement, Moody's global banking managing director Greg Bauer said: "All of the banks affected by today's actions have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities.".... 

However, as the review was announced in February, the impact on borrowers is likely to be muted as the downgrades were already priced in by the market.

Confirmation that transparency reduces relevance of rating firms

A Bloomberg article confirms that the more transparency provided to market participants, the less relevant the rating firms are.

The response to the Moody’s Investors Service downgrade of the biggest Nordic banks was rising bond and share prices. 

The reaction is the latest sign that investors are paying less attention to the views of rating companies and relying more on their own analysis to determine whether to buy or sell.

“We can see for ourselves just how strong the Swedish banks are so we don’t place much weight on what rating agencies tell us,” Nicklas Granath, a partner at Stockholm-based asset manager Norron AB, who helps manage about $200 million, said in an interview. “More and more the market is likely to take the same approach.” 

Even though Sweden doesn't require the banks to provide ultra transparency, it has a history of requiring the banks to recognize the losses hidden on and off their balance sheets.

As European policy makers try to reduce the dominance of rating companies in financial markets, investors are showing greater willingness to ignore Moody’s, Standard & Poor’s and Fitch Ratings.... 

“The Nordic banks are in general very solid and have currently no issues in funding,” said Espen Furnes, an Oslo- based fund manager at Storebrand Asset Management, which oversees $72 billion. “Moody’s is knocking down open doors with this. In these volatile markets the rating agencies are definitely behind the curve and, strangely enough, could be at risk of being considered irrelevant by the market during times when they actually do have something critical to say.”...

Keep in mind that the rating firms' business model is currently built around the idea of access to proprietary information.  Prior to their ratings being changed, banks have a chance to present the facts that they feel merits a higher rating.  Facts that are not always available to all market participants.

In Denmark, banks have started firing Moody’s after winning assurances from some of the country’s biggest investors that the opinions of ratings companies hold limited value.... 

Swedish banks, still among the best-rated in Europe, are now signaling they may rethink their cooperation with the rating company.

Cooperation that results in the rating firms having an informational advantage compared to other market participants.

“It is hard for” rating companies “to keep track and when you come close to them it is quite apparent they have difficulty following everything that is happening elsewhere,” [Swedbank Chief Financial Officer Goran] Bronner said. “The key is more transparency and then the market can decide.”

In particular, ultra transparency under which the banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With ultra transparency, the market participants have access to all the information they need to independently assess the risk of each bank.

Moody's weighs downgrading 114 banks in the EU

In an effort to remind the market that it may have access to information not available to other market participants, Moody's is talking about downgrading 114 banks in the EU.

Readers know that one of the reasons that banks should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is this ends the possibility of the rating firms having access to information that other market participants do not have.

Ultra transparency ends the rating firms' information advantage and the market participants' dependence on the rating firms.

With ultra transparency, the rating firms have to compete based on their analytical ability.

According to a Wall Street Journal article,

European banks are bracing for a wave of ratings downgrades in coming weeks that could intensify pressure on the fragile industry and further undercut recent efforts to defuse the Continent's long-running financial crisis. 

Under pressure from banks, Moody's Investors Service said Friday that it is delaying until early May its highly anticipated decision on whether to downgrade the credit ratings of 114 banks in 16 European countries....

Moody's said in a statement it is "taking an appropriately deliberate approach during this review process and will conclude when it is confident that all relevant information has been received and processed."

In the absence of ultra transparency, Moody's reminds the markets that it may have relevant information that other market participants do not.

While Moody's hasn't said whether and to what degree it will cut various banks' ratings, officials at multiple top European banks said they expect their grades to be knocked down at least one notch. 

The looming downgrades have ignited a scramble among some lenders and investors who fear the development could fan the smoldering crisis. 

In recent weeks, as Moody's has neared its decisions, big banks have been lobbying the ratings agency not to slap them with multi-notch downgrades, according to people familiar with the matter....

The source of this relevant information is the banks and their efforts to lobby Moody's on its ratings.

The costs associated with Moody's downgrades could be high, according to bank regulatory filings and people familiar with the matter. 

Lower ratings could prompt risk-averse institutions to withdraw deposits with banks. In addition, banks likely will be forced to put up additional collateral on derivatives transactions and in certain investment vehicles, including those housing pools of securitized assets, if their ratings are cut. 

"This is a serious problem for all European banks, especially in peripheral countries," said the chairman of a top European bank that expects to be downgraded. 

For example, Deutsche Bank AG said in its recent annual report that a one-notch downgrade of its credit rating could expose the bank to a €45 billion "funding gap."... 

RBS warned in a recent securities filing that a one-notch downgrade could require the lender to post an additional £12.5 billion of collateral. A downgrade "could significantly increase its borrowing costs and limit its issuance capacity in the capital markets," the bank said in the filing. 

Lloyds recently disclosed that if all major ratings agencies cut the bank's rating by two notches it could have to post an extra £28 billion in collateral tied to financial contracts with customers and the bank's secured funding. The bank also warned that such downgrades "could result in an outflow of £11 billion of cash."....

Some bank officials argue the impact of the downgrades is likely to be limited.... 

they say, investors and bank customers have had plenty of time to anticipate the downgrades and therefore won't be surprised.

Disagreement between Rating Agencies highlights need for ultra transparency

A Financial Times article looks at how the Rating Agencies are trying to win back investor trust in their ratings by critiquing the structured finance ratings of the other agencies.  They are able to do this because new regulations require that all Rating Agencies be given access to the data on the underlying assets.

The behavior of the Rating Agencies confirms that if ultra transparency into the underlying assets were provided for every structured finance security, market participants would use it.

The behavior of the Rating Agencies also confirms that eliminating the barrier to the data on the underlying assets allows additional experts to express their opinion on the quality of the deal.  Think of all the experts who don't work for the Rating Agencies that could express their opinion if the data on the underlying assets were freely available.

In short, the Rating Agencies show why investors are better off if each structured finance security is required to disclose the current performance of its underlying assets on an observable event basis.  Where an observable event includes, but is not limited to, a payment, delinquency, default or modification.

Credit rating agencies are sparring in public over new ratings as they seek to enhance reputations damaged during the financial crisis. 

Rating agencies were criticized for giving triple-A ratings to complex securities backed by risky mortgage debts that later fell in value. Since then, they have tried to improve their criteria, and the Securities and Exchange Commission has required that arrangers of structured finance deals make information available to the agencies, even if they have not been hired to rate the transactions.

It is only with access to information that the Rating Agencies can assess and rate the transactions that they have not been hired to rate. This was only made possible by the SEC partially lifting the opacity that surrounds structured finance transactions.

One byproduct of these efforts has been a tendency for rating agencies to disagree in public about the creditworthiness of complex securities. 

The latest example came this month when a near-$800 million bond deal backed by U.S. prime mortgages was sold to investors with triple-A ratings — provided by Standard & Poor’s and DBRS, a smaller competitor based in Canada — on some tranches. 

Fitch Ratings issued a statement saying it would not have rated the bonds triple A. 

It said it provided “feedback” on the transaction to the arranger, Credit Suisse , and “was ultimately not asked to rate the deal due to the agency’s more conservative credit stance”. 

Steven Vames, a Credit Suisse spokesman, said it was common for an issuer to engage multiple rating agencies to look at a deal and ultimately choose a subset of those agencies to rate it.

Otherwise known as ratings shopping.

But, with the disclosure of data, the Rating Agencies that were not selected have decided to express their opinion of the deal.

 In March,Moody’s said: “Some recent cases have come to market for which we believe increased risk has not been adequately mitigated for the level of ratings assigned by another agency.”

In particular, Moody’s faulted ratings issued by S&P, Fitch and DBRS on asset-backed deals. 

One portfolio manager who invests in asset-backed securities said: “It is good to have dialogue [among the rating agencies]. 

“Rating agency analysts know they will be scrutinized,” the investor added. “To the extent that [the dialogue] continues, it lets a lot of investors have a broader perspective.” 

Grace Osborne, head of mortgage-backed ratings at S&P, said: “Each of the credit rating agencies has their particular view on credit risk and they want to make sure the market understands that view and how [it is] different from the others. 

“It only helps to highlight where there is a divergence of opinion,” she added. “Knowing where [one agency] is seeing something where another didn’t is only an advantage to an investor in a marketplace.” 

Claire Robinson, a managing director in the structured finance business at Moody’s, said: “Post-financial crisis, the environment has changed. The market has been clear about the desire for diversity of opinion, and investors want more information.” 

Please re-read Ms. Robinson's comment as this is exactly why structured finance securities must be required to provide ultra transparency.

Rating agencies refuse to apologize for role in financial crisis

A Telegraph article describes how Moody's and S&P refused to apologize for their role in the financial crisis under questioning by the UK's Treasury Select Committee.

Representatives from Moody's and Standard & Poor's stopped short of apologising for the losses suffered by investors after they failed to spot the crisis brewing in the US sub-prime mortgage market, despite being repeatedly pressed by the Treasury Select Committee.... 

During the session, in which witnesses faced a hostile line of questioning from MPs, the agencies seemed to want to play down their role and stressed that investors should base their decisions on a range of opinions and information, and not just those of the ratings agencies. 

"Ratings are opinions. They are one piece of important information which is available to the market and investors, but there are many other pieces of relevant information around about credit decision making," Mr Crawley said. 

"We have been clear that we do not expect an individual investor, or at the other end of the spectrum a sophisticated asset manager, to rely solely on what we provide."...

As previously discussed, the rating firms' business model is built on the idea that they have access to relevant data that other market participants do not.  Hence, there is a reason that ratings are one piece of important information.

In the case of structured finance securities, prior to the financial crisis, it was assumed and the rating firms did nothing to dispel the notion that the rating firms had access to and used in their ratings current information on the assets that served as collateral for each security.

This current data was not available to the other market participants.

In the fall of 2007, the rating firms testified before the US Congress that they did not have current data on the performance of the underlying collateral and in fact that they did not have any different access to information on the underlying collateral than other market participants.

Mr Tyrie made it clear he was unhappy with the outcome of the session in his concluding remarks, and said issues including competition within the sector, regulation and the debt issuer pay model would be explored further. 

He said: "It appears that you have left the committee unconvinced that many of the problems attached to risk rating agencies in 2008 have yet been adequately addressed." 

Following the session Mr Tyrie added: "If even one of the ratings agencies had drilled down deeper into the structure of products developed [in the run-up to the crisis] and challenged them, we would all be in a much better place now."

The simple solution for eliminating the financial market's reliance on a small number of rating firms and unfreezing the current frozen structured finance markets is to require ultra transparency.

In the case of structured finance securities, ultra transparency is next business day disclosure of an observable event (for example, a loan payment, a delinquency, a default, a loan modification) involving the underlying collateral.

With observable event based reporting, market participants would have access to the current performance of the underlying collateral.  As a result, not just the current rating firms, but anyone who wants to could rate the securities.

Moody's attacks EU plans to overhaul ratings regulations

A Telegraph article describes Moody's response to EU plans to overhaul ratings regulations.  Moody's claims that the plans will undermine the integrity of and investor confidence in the European credit market.

Actually, the plans do not address the problem with ratings.

The problem is that the ratings come from companies that have access to information that is not made available to other market participants.  As a result, other market participants are reliant on the rating services assessing this information and accurately conveying the results of their assessment in a timely manner.

Regular readers know that under the FDR Framework this problem is done away with.  All market participants are provided access to all the useful, relevant information in an appropriate, timely manner.

As a result, market participants can analyze the data for themselves or pay a trusted third party expert to analyze the data for them.

By making the data available to all, the informational advantage that supports the rating services' oligopoly is eliminated and with it reliance by market participants on the rating services.

As the rating services frequently say, without this informational advantage they would have to compete based on their analytical skills.  While talk is cheap, the rating services say that competing based on analytical skills would be good for them as demand for their services would increase.

A better plan for the EU would be not to "regulate" the rating services but instead to implement the disclosure requirements under the FDR Framework.

In a letter to European finance ministers including George Osborne, Michel Madelain, chief operating officer at Moody's, said the changes would undermine investors' confidence. 

On Tuesday, Michel Barnier, EC internal market and services commissioner, will unveil "proposals for legislation" that could radically change regulation of credit ratings agencies. 

While the agencies have faced severe criticism during the financial crisis ... critics of Mr Barnier's widely leaked proposals say they will only increase debt market volatility. 

Most controversially, Mr Barnier plans to force debt issuers to rotate rating agencies. He also proposes to give the European Securities and Markets Authority (ESMA) powers to vet agencies' methodology and insist, in exceptional circumstances, such as bail-out talks, sovereign debt ratings should be suspended. 

The Association of Corporate Treasurers (ACT) said it was concerned over forced rotation in a market dominated by three main players - S&P, Moody's Investor Service and Fitch Ratings. 

Martin O'Donovan, ACT's deputy director of policy, said that while companies would welcome more choice there were "huge practical difficulties" for rotation in the current "oligopolistic" market. 

In his letter, Mr Madelain said allowing ESMA to "pre-approve" methodologies would "undermine credit rating agencies".

Will adding a label indicating minimum standards entice investors to buy European ABS deals? No!

A Bloomberg article reports that European issuers of ABS securities and a broker/dealer controlled lobbying group, the Association for Financial Markets in Europe, want to introduce a label indicating that the assets backing a structured finance deal meet a minimum standard.  According to the article, they are doing so to make the ABS securities more attractive to buyers.

There is zero chance that labeling the ABS securities will make them more attractive to investors.  This is just another attempt by the issuers and Wall Street to avoid having to disclose the current performance of the underlying collateral.

Why will this label not make the securities more attractive?

• The minimum standards for the underlying assets are already covered by the representations and warranties made in the deal documentation.  Since the information is already in the deal documentation, the label offers absolutely zero new information.

• The fact that the underlying assets met the minimum standards at one point in time does not mean that they still meet this standard at a future point in time.  For example, look at the decline in performance for so-called Prime mortgages in the US.  A label conveys zero useful information for valuing a deal in the secondary market.  Without current performance data, investors in the secondary market are blindly betting on the contents of a brown paper bag.

Disclosure of current performance data for the underlying collateral is the only way to entice investors to buy ABS securities.  It is only when investors know what they own that they will return.

The Association for Financial Markets in Europe and European Financial Services Round Table lobby groups are working on plans to label asset-backed notes that reach certain standards as Prime Collateralized Securities, according to two people familiar with the matter. 

A PCS working group, which also comprises investors, is scheduled to meet today to discuss the timing for the project and how to get better regulatory treatment for the debt, said the people, who declined to be identified because the discussions are private. 

The industry groups are working on the quality-assured brand after issuance in the asset-backed securities market in Europe tumbled by more than 80 percent since its pre-credit crunch heyday. Sales stalled in 2008 after bonds linked to U.S. subprime debt slumped, prompting investors to shun the hard-to- value securities. 

“In principle it’s a good initiative, but the implementation is very complex because of the different market practices in each European country,” said Alexander Batchvarov, the London-based head of structured finance research at Bank of America Corp. 

The PCS label would be designed to take account of new and existing regulation, said the people. Deals would need at least two triple-A credit ratings and reveal enough information about the underlying loans to be eligible for the liquidity operations of the European Central Bank and Bank of England, the people said. The ECB, BOE and European Investment Bank have been consulted on the plan, according to the people. 

As this blog has previously documented, the ECB and BoE have disclosure requirements for the underlying loan performance information that are inadequate for complying with Article 122a of the European Capital Requirement Directive.  Both Moody's and S&P have testified before Congress that these disclosure requirements are not adequate for timely rating (the equivalent of valuation) of the securities.

The inclusion of two triple-A credit ratings does not make ABS securities more attractive.  Investors learned from the sub-prime/CDO debacle to not rely on the credit ratings when it comes to valuing and investing in structured finance securities.

... The quality tag will be available for bonds backed by residential mortgages, small- and medium-sized company loans and consumer loans, the people said. 

“To make this initiative work it’s key to get the ECB and BOE to give the labelled issues better treatment in their liquidity operations, or to persuade the European Commission to require less capital for banks and insurance companies that buy these bonds,” Bank of America’s Batchvarov said.

Since September 2008, the ECB and BoE have been the major "buyer" for these securities. These securities are "purchased" by being eligible to be pledged to the ECB and BoE for their liquidity operations.

The goal of the ECB and BoE is to bring private investors back to the market so that they do not have to fund these securities.

Simply slapping a label on these deals will not work to attract investors.  The ECB and BoE know that it will take disclosure of current performance data for the underlying assets.

SEC looks at S&P use of 'dummy' assets in rating CDO

The Wall Street Journal reported that the SEC is looking at S&P and its use of 'dummy' assets in rating CDOs.

Whether or not the SEC pursues this case against S&P, the use of 'dummy' assets makes the case for asset level (loan-level) disclosure for all structured finance securities.  Simply put, the SEC is looking at the issue of how can you value/rate a security when you do not even know what is in the security.

Your humble blogger has been making this point about the need for current asset-level disclosure for structured finance securities since before the credit crisis.  Without this disclosure, market participants do not have all the useful, relevant information in an appropriate, timely manner.

It is nice that the US government in the form of the SEC has come out and formally agreed with me on the need for current asset-level disclosure for structured finance securities.

U.S. securities regulators are zeroing in on the use by Standard & Poor's of fictitious "dummy" assets when it assigned a triple-A credit rating to a $1.6 billion mortgage-bond deal that imploded during the financial crisis, according to a person familiar with the matter. 

S&P's parent company, McGraw-Hill Cos., said Monday that it had received a so-called Wells notice from the Securities and Exchange Commission. A Wells notice is the agency's warning to financial institutions that they could face civil charges. McGraw-Hill said the SEC is weighing civil enforcement action against the firm for its ratings on a collateralized debt obligation called Delphinus CDO 2007-1 issued in July 2007 as the housing market was taking a turn for the worse. 

The SEC is alleging violations of federal securities laws, McGraw-Hill said in a news release. The company said S&P has been cooperating with the regulator on its probe into Delphinus. A spokesman for the SEC declined to comment.

Lawmakers, regulators and investors have trained their cross hairs on S&P and its peers for assigning rosy ratings to thousands of complex securities that were later downgraded within the span of a few months, deepening the crisis. 

The S&P investigation is one of a number of probes by the SEC's enforcement division, headed by Robert Khuzami, into the complex mortgage-bond deals known as collateralized debt obligations. 

CDOs, which are pools of subprime mortgages and other assets that were sold in slices to investors, had emerged before the crisis as popular and profitable products on Wall Street. But the housing market's collapse exposed both the banks and their investors to billions of dollars in losses and left in its wake a raft of legal and regulatory headaches. 

S&P originally assigned its highest rating to the deal based on "dummy," or hypothetical, assets, then maintained that triple-A rating even though bankers had replaced them with lower-quality assets that didn't meet the firm's ratings standards, according to emails among S&P analysts that were disclosed in congressional testimony. 

Jack Chen, a former Moody's analyst who now runs his own consulting firm, said it isn't uncommon for credit-rating firms to use "dummy" assets to determine a final rating for a CDO, because some of the deals may have assets traded in later. 

What is problematic with S&P's rating of Delphinus is that the assets that replaced the "dummy" assets were of a lower quality than those hypothetical assets S&P had used to issue the ratings, said Mr. Chen, who has reviewed the S&P emails that were released. 

Frank Raiter, a former S&P managing director who had retired by the time Delphinus was rated, told lawmakers in April 2010 that S&P's dependence on fictitious assets that were later replaced by lower-quality securities "looks like a bait and switch."

Had the investors had current asset-level data, it would not have been possible to do a bait and switch.  Investors would have been easily able to see that the assets did not meet the quality standards that were represented in the offering documents and would not have purchased the deal.

Asset managers reduce reliance on rating agencies

As predicted under the FDR Framework, a Reuters article describes how asset managers are using disclosure to reduce their reliance on rating agencies.

Regular readers know that this blog has recommended that disclosure is the key ingredient for replacing rating agencies in financial regulations.  If there is disclosure, market participants can do their own homework and not rely on the rating agencies.

Some of the world's largest asset managers are cutting ties to credit rating agencies, potentially signalling the beginning of the end of their grip on global financial markets. 

Managers responsible for billions of euros of fixed income investments are reviewing relationships with the likes of Fitch Ratings, Standard & Poor's and Moody's Investors Service, whose calls on Portugal, Ireland and the United States have roiled central banks desperate to avert a collapse of the Euro zone. 

Fund firms contacted by Reuters said rating agency research tended to be backward-looking and superficial, and often encouraged the kind of speculation that has recently dragged down Italy, one of the world's largest government bond issuers. 

"We have cancelled our subscriptions to two of them and they haven't left us alone since. It has been very irritating," the head of sovereign debt investment at one large European bond investor told Reuters on condition of anonymity. 

"It would be naive to blame the agencies for everything that went wrong during the financial crisis but anyone who relies on a third party to form their investment opinions is headed for trouble ... clients pay us to make those decisions, it would be completely wrong of us to abdicate that responsibility." 

Investors say they have steadily reduced reliance on external research providers ever since rating agencies slapped high ratings on complex structured financial investment products such as collateralised debt obligations (CDOs) which later turned out to be far riskier than initially assessed. 

A broad push for development of proprietary research teams shows credit ratings agencies have never fully regained the trust of some of their most important buy-side clients, some of whom are still counting the costs of belated warnings of a change in the risk profile of debt issuers...

"Ultimately, we believe that the research which we produce 'in-house' is more detailed, more forward looking and timelier than that of the agencies," Garrett Walsh, head of credit research, Europe and Asia at Pioneer Investments told Reuters. 

Pre-crisis, Pimco, the world's largest bond investor, used to limit its own internal ratings to private corporations. In 2008 it extended this to Western sovereign credits and now runs its own internal ratings system for all issuers of debt. 

"We will compare our rating to the external ratings but we try to make our decision independent of what the major rating agencies are saying and that has certainly accelerated," Andrew Bosomworth, head of portfolio management in Germany at Pimco, told Reuters. 

"We know what's inside what we rate," he added. 

Daniel Noonan, a New York-based spokesman at Fitch said his company advised investors to use its ratings and commentary alongside a range of inputs when making investment decisions. 

"We think over-reliance on any single input, including a credit rating, is unwise. We continue to see strong demand for our opinions and products, and as a result our business is growing," he said. 

"Investors are undoubtedly doing more of their own research, which we think is appropriate. However, they still need benchmarks to support their research efforts," added Michael Privitera, a member of S&P's Valuation and Risk Strategies team. 

While credit rating agencies may be losing influence on the investment decisions of the world's largest asset managers, sudden ratings calls can still trigger massive sell-offs from passively-managed funds which track an index whose composition is shaped by the ratings given by the credit agencies. 

When a country's debt is downgraded below investment grade it is pushed out of an index, forcing passive investors to sell their holdings and crystallize hefty losses that could shrink when the immediate rush for the exit subsides.... 

Some investors say credit default swap prices -- the cost of insuring debt against default -- are a much better measure of risk than credit ratings....

"Our approach seems to have quite a high correlation to 5-year CDS index which is a decent measure of value in bond markets and a much greater correlation than rating agencies have. In general markets tend to move ahead of rating agencies," BlackRock's Ewen Cameron Watt said.

Basel III capital requirements, Dodd-Frank ban on using credit ratings in regulations and disclosure by banks

A Reuter's article highlighted how the Dodd-Frank Act impacts the adoption of Basel III capital requirements in the US.

The Act bans the use of credit ratings in US bank regulations.  However, these same banned credit ratings are used to in determining the risk-weighting of an asset for compliance with the Basel III capital requirements.

The question is what can be used as a substitute for relying on the credit ratings for three or four firms?

Under the FDR Framework, the substitute is to replace the opinion of three or four firms with the opinion of the market.  This is easily achieved by requiring disclosure of each bank's current asset and liability-level data.  Market participants including competitors, credit and equity market analysts, and valuation experts will use this data to perform their own risk assessments of the assets on the individual bank's balance sheet.

Rather than having to rely on three or four firms, regulators can now rely on the assessment of risk by the market participants.

The United States' ability to implement global capital rules is being made more difficult by a provision in the Dodd-Frank financial reform law, JPMorgan Securities said in a research note released on Friday. 

The 2010 law bans the use of credit agency ratings, such as those provided by Moody's Corp and McGraw-Hill Cos' Standard & Poor's, in U.S. banking regulations. 

That is a problem for bank regulators, who currently have no good alternative to the credit ratings they use to help judge the risk on banks' books when determining capital requirements. 

... The ban on credit ratings in U.S. regulations will also likely make it more difficult to implement the latest sweeping global capital accord reached as part of the Basel III agreement, the note said. 

That agreement does not have to be fully in place until 2019, but U.S. regulators hope to begin issuing draft rules by the end of this year. 

... Last summer U.S. regulators sought comment on what could be done to replace credit ratings in their rules. They say good alternatives have yet to materialize. 

The Dodd-Frank change has been a burr in their saddle. 

"The Dodd-Frank Act's prohibition against the use of credit ratings also will impede our efforts to achieve international consistency in the implementation of Basel III," acting Comptroller of the Currency John Walsh told the House Financial Services Committee on June 16. 

The Basel III agreement is a response to the financial crisis and aims to force banks to meet tougher capital standards so they can better withstand a financial shock. 

Regulators have asked the U.S. Congress to amend the law to deal with the credit rating problem, but that seems unlikely for the foreseeable future. 

One possible outcome is that regulators will require banks to perform their own risk assessments to replace the work of credit rating agencies, and the banks' assessments would be reviewed by a third party, said Karen Petrou, managing partner at Federal Financial Analytics, a regulatory policy consulting firm. 

That third party could wind up being the credit raters, she said. 

"This is a sort of halfway house," she said.