We are a big fan of a clearly articulated ratings methodology and approach: it allows users to trust, but verify, to the extent they wish to perform their own due diligence.
If a methodology is well defined, users can spot when the rating agencies have slipped up and encourage them to correct it. This provides a positive, reinforcing feedback loop: it limits the potential for damage (i.e., large downgrades when errors are noticed suddenly). Of course, to the extent investors can show that the ratings used do not adequately reflect the rating agencies’ then-current methodologies, the rating agencies may worry they’re increasingly exposed to litigation risks.
The problem is that ratings errors — actual system failures – are not infrequent (see here and here for examples). Similarly, their methodologies change quite frequently, which is why we think well articulated criteria are important.
When Moody’s in April 2009 downgraded the ratings of Ambac’s insurance subsidiaries (Ambac Assurance Corp. and Ambac Assurance UK Limitied) to Ba3 (junk) from Baa1, Ambac responded by saying:
“While Ambac believes that Moody’s is entitled to its opinion of Ambac’s financial strength, it notes that this is the tenth such opinion change since January 2008.”
We wrote a piece back in May about the lack of transparency in rating agency methodologies. The piece provided both sides of the argument: why the rating agencies felt they were being transparent, and why market participants felt otherwise.
Our recent experience is that despite the encouragement of the Dodd-Frank Act towards enhancing ratings transparency, the large rating agencies — with the possible exception of Moody’s — are in many cases being increasingly less transparent about their ratings methodologies.
This is a particular concern given the increasing interest the rating agencies are themselves seeing in non-traditional investments (see here) and that Goldman Sachs’ president Gary Cohn is seeing in pushing risky activities into the less regulated, opaque shadow banking system (see here).
One has to wonder if it’s purely lip-service when S&P president Deven Sharma writes for the Financial Times that “capital markets thrive on certainty” while at the same time their ratings methodologies change rapidly.
Yesterday SCI printed a criticism of S&P’s newly proposed bond insurance ratings criteria. The author, managing principal of Grenadier Capital, notes that the criteria are “confusing,” that there is a lack of disclosure surrounding the circularity inherent in the process, that the model inputs are ill-defined, that “S&P gives itself wiggle-room to blame the management of the bond insurers, as opposed to its own failings in the actual ratings process.”
He questions whether the convoluted components and stresses proposed in S&P’s 39-page manual indicate that S&P lacks confidence in its own ability to rate the insurers’ guaranteed transactions. He wonders whether investors will ever again gain comfort in a bond insurer’s ratings if the proposed criteria are adopted.
Posted on February 9, 2011
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