Nomura analyst sceptical about Nera’s ratings study

Moody’s Investors Service awarded a contract to Nera, a Marsh & McLennan company, back in late 2001 to conduct an independent study of structured products ratings processes. Published last week, the study investigates if differences in rating agencies’ methods create systematic differences in the performance of rated structured finance products.

The impetus for the study was the contentious issue of how, when rating a structured finance transaction, agencies treat underlying securities that they have not previously rated. One approach commonly used for collateralised debt obligations (CDOs), for example, is known as notching. This is a practice whereby one agency produces its own estimate of a rating by adjusting the ratings given to structured finance collateral by other agencies.

Nomura’s Adelson said in a research note that proponents of notching might view the study favourably because Nera could not reject the hypothesis that ratings from different rating agencies perform differently. “However, Nera could not reject the converse either,” the New York-based analyst added. This ambiguity should mean structured finance instruments rated by both Standard & Poor's and Moody's will continue to price with tighter spreads than otherwise similar instruments that lack ratings from either of the two, according to Adelson.

If the equivalence of different agencies’ corresponding ratings cannot be analytically supported, “entire regulatory regimes might be based more on wishful thinking than on fact”, Adelson said. Referring to the use of ratings in determining regulatory bank capital, and the implicit presumption of equivalence for each rating grade, he added: “If those presumptions cannot be defended, the public and Congress may question and challenge the soundness of the regulatory framework.”