No Nera for Fitch

Moody’s and S&P claim that a recently commissioned study supports their belief that not all agencies’ ratings are equal. Saskia Scholtes examines the notches that have driven a wedge between them and Fitch

The long-awaited publication of a study into structured finance ratings by economics consultancy Nera (National Economic Research Associates) has fallen far short of resolving the dispute it was commissioned to settle – prompting a string of contradictory statements from the rating agencies. Commissioned by Moody’s in late 2001, the study was an effort to respond to criticism, especially from rival agency Fitch Ratings, about the practice of ‘notching’ in the ratings for the underlying assets of collateralized debt obligations.

When a rating agency rates a CDO, but does not rate all of the underlying assets, it will use a rating from a rival agency for those assets. Fitch’s view is that it would normally give the asset the same rating as Standard & Poor’s and Moody’s – in other words, it believes that ratings from the other two agencies are equivalent to its own. But Moody’s and S&P argue that ratings from other agencies are not equivalent to their own, and may ‘notch’ them downwards because the ratings have been assigned in a different way.

When rating a pool of securities, Moody’s and Standard & Poor’s require that they rate 80% of the underlying collateral. According to Fitch, for the remaining 20%, S&P and Moody’s typically discount a Fitch-rated security by between two and six notches, if they choose to accept the rating at all. This occurs frequently in the case of CDOs of asset-backed securities where Fitch rates more of the underlying assets than Moody’s.

While the issue of notching has been a long-running debate, the current furore started in mid-2001 at the annual meeting of the Commercial Mortgage Association. Various market participants contended that Moody’s notching practices were unjustifiably harsh, with the haircut on some securities being as much as six notches.

Over the next few months, the debate became increasingly heated. In particular, Fitch argued that the practice was used to boost Moody’s market share in structured finance ratings at Fitch’s expense by forcing issuers to get a Moody’s rating on the underlying assets. Moody’s response was to commission the Nera study.

This independent study was to analyze the performance of structured finance ratings for all three rating agencies: Moody’s, S&P and Fitch. It would hopefully provide a conclusive response to the question of whether ratings from the three agencies should be considered as equivalent, or whether they perform differently over time.

In the meantime however, the rating agencies pecked away at the issue. In March, Moody’s published the first in a series of reports to defend its notching practices. In response, Fitch commissioned a survey of structured finance professionals that found that 52% opposed notching, and that by a margin of more than four to one, senior structured finance executives believed there is “no substantial or credible body of evidence to support the notching practices of Moody’s and S&P from a credit perspective”.

The Bond Market Association, which had been lobbied by Fitch into forming a task force and had scheduled a roundtable on the notching issue, later abandoned the effort because it had all the hallmarks of a circus. A public relations war was underway: while S&P continued to withhold comment, Moody’s continued to issue study after study in support of the argument that the various ratings perform differently, and Fitch responded with commentaries with titles such as Should Moody’s notch its own ratings?

On November 6 this year, Nera at last released its study. At first glance, it does not show the results that either side was hoping for. One structured finance analyst has described the study as “disappointingly inconclusive”.

For the rating agencies, however, the 260-page study seems to have something for everyone. Moody’s responded to its publication with a press release entitled Moody’s says Nera study confirms differences among rating agencies. Fitch’s release was entitled Differences in structured finance ratings of major rating agencies are small.

And there was also something for S&P. Their release read: “We are pleased that this study demonstrates the stability, consistency, and timeliness of Standard & Poor’s ratings, as well as our leadership position in the structured finance markets.”

So the Nera study has only added confusion to the debate. The authors even had the foresight to include the caveat: “As with any set of empirical findings, there may be alternative interpretations that could be consistent with the data.”

Proponents of notching, such as Moody’s, have seized upon the fact that the study was unable to reject the hypothesis that ratings from the different agencies perform differently. According to the study: “Comparisons of reported ratings changes indicate some differences between each agency’s single-rated issues and issues rated by other agencies…” And for speculative-grade and low investment-grade categories of debt, “it is not possible to rule out that performance difference equivalent to several notches do exist”.

Brian Clarkson, senior structured finance analyst at Moody’s, says that this is no bad thing: “Having multiple opinions about credit quality of securities is good for the market. We’ve been told time and time again by investors that they value a diversity of high-quality, independent, objective opinions.”

S&P also takes this position. In a conference call responding to Nera’s findings, and commenting on the practice of notching for the first time, S&P structured finance analyst Tom Gillis would only say that when the study was commissioned, S&P did not feel its notching policy would change. “There is no one way of looking at risk, so we feel that maintaining independent judgment on ratings is important,” he says.

But at Fitch, chief credit officer Bob Grossman points to Nera’s findings that the differences found between the ratings analyzed were in fact very small. The study found that on bonds jointly rated by two agencies and spanning more than a decade, on average S&P rated only 0.1 notches higher than Fitch, and Fitch rated only 0.6 notches higher than Moody’s. According to Grossman: “This is close enough to consider these ratings broadly similar. If the Nera study had included the ratings data for 2002 and this year to date, we think the differences would have been even smaller.”

So it seems that the debate over notching is unlikely to progress much further in the near future. Mark Adelson, a structured finance analyst at Nomura, says: “The fact that the agencies take different approaches to defining their ratings arguably makes this debate an exercise in futility. Ratings based on expected loss – Moody’s – and ratings based on likelihood of default – S&P and Fitch – are fundamentally different. The two ratings do not represent two opinions about the same thing, but two opinions about two different things.”

However, Adelson says that Nera’s study has, nevertheless, highlighted an extremely thorny problem for the corporate bond markets. If a detailed independent study was unable to prove that the ratings of the officially recognized agencies are equivalent, but rather found small differences between ratings, “it erodes the conceptual basis for using ratings in regulations. Unless studies such as Nera’s can affirmatively conclude that ratings are equivalent, policies and regulations that presume equivalence may be ill-conceived and detrimental.”

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