Who would be a rating agency at the moment? First came the humiliating U-turn by Moody's Investors Service in March, which saw it having to revise its new joint default analysis methodology in the wake of stinging criticism from dealers and analysts. Now, the agencies have come under fire over their ratings of US subprime mortgage securities, and in particular, collateralised debt obligations of asset-backed securities (CDOs of ABSs).
Moody's put 184 tranches of 91 CDOs backed primarily by subprime residential mortgage-backed securities (RMBSs) on review for possible downgrade, while Standard & Poor's lowered its ratings on 93 tranches from 75 CDOs of ABSs. Most of the downgrades are limited to the lower parts of the capital structure. However, with delinquencies on subprime mortgages expected to accelerate - particularly for the 2006 vintage - there's even talk that AAA-rated tranches could come under threat, particularly for transactions that include CDO of ABS buckets.
Granted, most analysts still think that's unlikely. But the downgrades, and perceived threat to AAA tranches, have raised serious questions about the reliability of ratings. The bottom line, say critics, is how can the senior tranche of a CDO garner the same AAA rating as a US Treasury bond? Surely the fact that spreads are wider for the CDO tranche proves the agencies have had the wool pulled over their eyes?
There are, in fact, reasons other than pure ratings arbitrage as to why the spread on an AAA-rated CDO tranche would be wider than a straightforward bond with the same rating - for instance, structurers are able to extract value from the correlation of the underlying reference assets.
This aside, these structures are extremely complex to model and require a variety of assumptions on loss rates, prepayments and correlation, among others. Have the rating agencies got it right? Maybe not. S&P announced in July that it is modifying its rating methodology for CDOs of subprime RMBSs in response to loss rates being far in excess of historical precedents.
Despite the fact that it is not just the rating agencies struggling to analyse the risks of these instruments in the current environment, the downgrades have eroded confidence in the reliability of ratings. Privately, regulators are concerned that some investors are buying complex CDO instruments based on rating, without conducting a full analysis on the portfolios themselves. With Basel II set to be fully implemented in Europe from next year, ratings will become more important than ever, and will dictate the level of regulatory capital held by banks using the standardised approach.
With this in mind, it would perhaps not be surprising if regulators entered the debate as to the role of rating agencies. Certainly, the regulators Risk has spoken to are watching how rating agencies react to the subprime crisis with interest.
Nick Sawyer, Editor.
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