It's time to revamp ratings modelFont Size: Decrease Increase Print Page: Print MARTIN COLLINS: John Durie | November 15, 2008 Article from: The Australian AUSTRALIA'S regulatory zeal, inspired by the credit crisis, is commendable but sometimes misguided.
The move to license rating agencies is the latest example.
Superannuation Minister Nick Sherry earlier this week unveiled his plans of licensing rating groups and requiring them to conform to international standards and codes of conduct.
The underlying theme is transparency, which is great. But in this case it is the entire model that needs to be changed.
Around the same time, in Europe, its internal markets commissioner Charlie McCreevy outlined his plans, which also revolve around licensing. However, they go further by requiring ratings agencies to disclose the assumptions, model and methodology behind their work.
Likewise, in order to prevent conflict, ratings agencies are not allowed to provide advisory services.
As most of the big ratings agencies like Fitch, Moody's and S&P are international groups, the region with the toughest regulations will set the rules for the world. Thus, the McCreevy standards will effectively set the rules in Australia.
The response from Sherry and McCreevy is understandable, because it is hard to fathom how a financial product with a triple A rating can collapse with the ease that mortgage bonds did this year.
Sherry's proposals also apply to retail rating agencies like Morningstar, Van Eyk and the like that rate superannuation funds for retail investors.
The concept is that, if a fund has a five-star rating it should be good and provide better returns. Such ratings are based on historical performance, which is never a perfect guide to the future and particularly now, when the future is so uncertain and the market so fundamentally different.
Sherry's focus on conflicts of interest is worthy. But while he is at it, he should have a look at the multiple conflicts that exist among the big asset consultants who run their own fund platforms. But you have to wonder whether he is trying to attack the problem from the wrong angle.
In theory the best regulator is the market, but when the market plainly doesn't work, governments must move in.
Yesterday at a Congressional hearing in Washington, Renaissance Capital's James Simons blamed the credit ratings agencies for the credit crisis. It wasn't a bad effort given the hearing was to work how to regulate his industry -- the $2trillion hedge fund industry.
While he was at it, he also slammed regulation of investment banks, which was cute given he is one of their clients. But it just goes to show how everyone wants someone else to take the blame and carry the regulatory burden.
The hedge fund chiefs who fronted Congress were all happy for increased disclosure, which was a smart response given that's what will be happening.
The Australian stock lending industry could also do itself a favour by fast-forwarding the transparency it has agreed to under the new short selling regime. From Wednesday, non-financial stocks can be shorted, so long as the seller has borrowed stock and the broker must ask the client whether the sale is a short sale.
Given continued volatility, who knows what will happen. There is some talk about attacks on consumer discretionary stocks such as Harvey Norman and JB Hi-Fi, along with the likes of Fortescue and Asciano.
The big four custodians could help themselves by disclosing which stock they have lent before Wednesday to help guide the market. Likewise, it would be best if those brokers and hedge funds, complaining about being required to report short sales, kept quiet lest ASIC lets loose with the promised increase in regulation.
Australian bank chiefs are keen to blame credit rating agencies when they buy dud products, but in the next breath boast they are among the only AA-rated banks in the world. They can't have it both ways. Either the ratings agencies are shams or they aren't.
The real problem is the inherent conflict of interest in the rating agency model, because the person who wants the rating pays for it.
In the midst of the inquiries into ratings industry, according to The Economist, emails were discovered where one analyst, when asked why he was rating a bit of toilet paper, replied: "We rate everything, even if it is structured by cows we rate it."
If someone will pay you to rate their paper and that's your business, then you rate it.
So, if Ralph Norris at CBA wanted S&P to rate his bank, he would pay tens of millions of dollars for the pleasure.
Surely, it would be better if the people buying the paper were the ones who paid, because they would get to pay the firm that they thought provided the best service for investors.
The rating agencies would reject this because the reality is, a big bank could afford to drop $20-$30 million on a credit rating, but a fixed income wanting to park $1 million on a Four Pillar bank note would only pay a fraction of the price.
By creating a licence system, governments would tend to entrench the oligopoly controlling the ratings industry because they join a select club.
The industry can be counter-cyclical in that people need it more when the market is difficult. If banks really rely on a ratings agency to judge a financial product, as NAB did with some of its US-structured investments, then the real fool is the bank, not the ratings agency. Banks are meant to be risk managers, but in the bull market they outsourced their core competence.
If the market worked, given their appalling performance no one would buy rating agency products, but anyone who spoke to NAB's Ahmed Fahour last Monday after the bank's capital raising would have heard him marvel at the fact that NAB actually had its credit rating increased from negative to stable BB. It was indeed good news, but then we weren't meant to trust rating agencies.
Big equity managers like Perpetual and AMP have their own analysts who they turn to first before buying a stock and banks should do likewise.
Not everyone can afford their own credit analyst, which is where rating agencies come into their own and why the system must be changed so that it is the purchaser not the issuer who pays for the service.
This would be a better response than to fall back to old regulatory models as Sherry has done and, worse, as the ACCC is suggesting by adding new competition thresholds to attempt to crack down on creeping acquisitions by taxi companies and supermarket chains.
Once again, the regulator is looking in the wrong direction for a perceived rather than actual problem, because if it's a concentrated industry the Government is worried about then let's look for other ways to counter the problem.
Instead, the proposed rules look more like a market share limit than a genuine desire to promote competition.
