Basel committee outlines reforms for rating agencies

The Committee on the Global Financial System (CGFS) – a group affiliated with the Bank for International Settlements that monitors developments in financial markets for the G10 countries – released on July 4 its findings on failures in structured finance ratings.

The report – called 'Ratings in structured finance: what went wrong and what can be done to address shortcomings' – was put together by a CGFS study group chaired by Nigel Jenkinson, executive director of financial stability at the Bank of England.

The group described how deteriorating performance of subprime mortgages led to a re-pricing of asset-backed securities, undermining confidence in the ratings of structured finance products. “The turmoil has raised questions about the effectiveness of credit rating agencies’ (CRAs') assessments of risks in rating complex financial products,” the report stated.

Furthermore, the study group highlighted the “overdependence on ratings as well as other weaknesses in investors’ risk management”.

Three factors were cited as the main contributors to poor ratings performance. First, the CGFS said CRAs underestimated the severity of the housing market downturn in the US. Specifically, CRAs failed to spot a widespread deterioration in underwriting standards, which led to them not fully appreciating the level and correlation of defaults. CRAs, the group reported, assumed a low probability of a nationwide decline in house prices on the basis that such a phenomenon had not occurred since the 1930s.

The second contributory factor concerned limited historical data, which added to model risk. In particular, data on subprime mortgages was largely confined to a period of benign economic conditions, with little information on how loans would perform during times of steep house price declines. Additionally, the assumption that geographical diversification in the underlying asset pool would lessen the probability of a large number of defaults proved incorrect.

Third, the study group claimed, CRAs underestimated the originator risk factor. With little diversification in terms of originators, issuers and services, this left investors vulnerable to correlation risk. As well as pointing out weaknesses in the practices of CRAs, the report set out five lessons that could be learned. First and foremost, ratings should support, not replace, due diligence done by investors. The four other lessons were related to the agencies themselves, with the CGFS advocating that CRAs improve information on their underlying ratings; provide better data on key risk factors; and also take system-wide risks into account.

The CGFS also advised that structured finance ratings should be more clearly differentiated from single-name credit ratings - an idea that has gained support from investors and regulators in recent months. Possible ways to do this include having a separate rating scale (ie, structured finance deals could be rated on a numerical rather than letters-based scale) or have an asset class suffix, so that a triple-A residential mortgage-backed securitisation, for example, would be rated AAA.sf instead of AAA.

A number of other ways to distinguish structured finance ratings were suggested, including attaching multi-dimensional measurements to the standard AAA version so that a rating would include information on volatility, rating confidence and quality of input parameters.

In addition to the five lessons, the CGFS outlined 10 recommendations – with separate proposals for CRAs and institutional investors – to address weaknesses. Investors, for example, are urged to review internal procedures on how ratings are used for investment decisions; while improving transparency should be the main focus for CRAs.

Staying on the transparency theme, a group of nine European and global trade associations, including the Securities Industry and Financial Markets Association, released on July 2 a list of 10 industry initiatives to increase transparency in the European securitisation market. The move came as a response to calls for improvements from the likes of the European Council of Finance Ministers and the Financial Stability Forum.

The two main objectives of the group are to increase transparency in the reporting of securitisation exposures under the capital requirements directive, which are set to be finalised in October, and to aggregate key data on European and US securitisation transactions on a quarterly basis, while also releasing monthly updates on spread and price data.

See also: Fitch unveils new structured product ratings
Restoring ratings