Credit Ratings Agency Answers gtnews Readers' Questions
A (Barry Hancock, managing director, Standard & Poor’s): An S&P rating has an important but limited role – it is an opinion about creditworthiness and the relative likelihood of a security defaulting, not about its market value, the volatility of its price or its suitability as an investment. While the performance of many of our ratings of recent US residential mortgage-backed security (RMBS) and collateralised debt obligations (CDOs) is worse than has been the case historically, much of the difficulty being experienced in the markets – such as the significant mark-to-market writedowns taken by financial institutions – is due to declines in market value, not defaults.
We have seen widespread volatility in the market value of many structured securities (and evaporation of their market liquidity) and around 40% of our ratings on US housing-related securities have been downgraded, reflecting our view of their changed creditworthiness. However, defaults, which are what our ratings specifically address, have been limited to date – as of January 2009, only 3% of the US$3 trillion of US housing-related securities rated by S&P since January 2005 had defaulted.
That said, we recognise that a number of the assumptions we used in our analysis of many US RMBS and CDO ratings did not hold up. Put simply, we did not fully anticipate the extent of recent, unprecedented declines in the housing and mortgage markets. We have reflected on this, are committed to doing our part to enhance transparency and confidence in our ratings and the markets, and are making several changes in our business.
A (Hancock): The acid test of our credibility is our track record over time. S&P has been in this business for over 100 years and studies on ratings trends and performance (see www.sandp.com) have repeatedly confirmed that our ratings – both of corporate debt and structured securities – have been highly effective in informing the markets about deterioration and improvement in credit quality. Between 1978 and 2008, the average five-year default rate for investment grade structured securities is around 1%; for speculative grade securities it is around 15%. That is broadly comparable with the equivalent default rates for corporate bonds. Ratings have been, and we believe will continue to be, an important tool for investors and others looking for a common and transparent language for evaluating and comparing creditworthiness, across sectors and geographies.
We constantly learn from experience and have listened carefully to the many views that have been expressed about what we do. We are focusing on two key efforts: first, we are making adjustments to our assumptions and analysis so that our current ratings reflect our best opinion of credit risk based on all information learned to date; second, we are taking concerted steps to improve our processes, enhance our transparency and restore market confidence in our rating opinions.
A (Hancock): We believe that sound, internationally consistent regulation of CRAs can benefit the market by helping support confidence in credit ratings. Sound regulation should focus on overseeing agencies’ policies and procedures that address the integrity and transparency of the analytical process. At the same time, it should preserve the independence of ratings opinions and methodologies. Because of the global nature of ratings and the capital markets, any regulatory framework needs to be globally consistent and built on a set of standards commonly accepted by the market and regulators internationally, as the G20 governments proposed late last year. Such a consistent regime would help underpin investors’ confidence in the comparability, and hence usefulness, of ratings around the world. The global markets need the certainty of a co-ordinated, consistent approach.
A (Hancock): We are, in fact, embracing the principle of distinguishing structure finance ratings from other ratings. Policymakers and regulators have made clear they would like CRAs to do so either by creating a separate scale or by providing more information about the special risk characteristics of structured ratings. While investors are adamant that they want a single ratings scale that can be used to compare credit risk across all asset classes, at the same time they want to see more details about the analysis underpinning our ratings. We have responded by increasing the amount and usefulness of the information we publish on structured finance ratings, including our underlying assumptions for various asset classes, stress tests for our ratings, and scenario analyses around the factors that could drive a ratings change. That is in addition to our established practice of making our ratings criteria and models publicly available. The result should be that investors are better equipped to take a more informed and independent view of credit ratings and credit risk on structured securities.
It’s worth noting that S&P’s AAA ratings – both on structured securities and corporate bonds – have historically had very low default rates. Although the market valuation of many AAA structured securities has fallen heavily in recent months, relatively few have defaulted to date. Of the almost 30,000 AAA ratings issued by S&P on structured securities since 1978, only around 0.5% have ever defaulted. That is broadly comparable with the historic default rate for AAA corporate bonds. Triple-A ratings can and do change, both in the corporate and structured bond markets, and they can and do default. However, it remains the case that they default much less frequently than securities that were originally rated lower.
A (Hancock): We have affirmed the ratings on the US despite our judgment that fiscal risk has noticeably increased because we expect that the fiscal deterioration will be temporary and that the country’s other credit strengths will withstand current pressures.
The ratings on the US primarily reflect our opinion of the sovereign’s high-income, highly diversified, and exceptionally flexible economy. The ratings also reflect our view of its strong track record in terms of growth-enhancing policies, as well as the unique advantages coming from the US dollar’s role as the key international currency. In our opinion, these strengths continue to outweigh the US’s weakening current-year fiscal performance, growing risks in its financial sector, longer-term challenges associated with its entitlement programs, and the nation’s weak external position.
A (Hancock): As the market knows, we have certain information requirements in order to rate a transaction and we rely on issuers and originators providing us with this information in good faith. It is not, and never has been, our role to audit this information. Among the steps we have taken in recent months to further strengthen our ratings, we are seeking more information about the processes used by issuers and originators to assess the accuracy and integrity of their data and their fraud detection measures, so we can better understand their data quality capabilities. We will take this into account in our analysis.