Credit ratings agencies still under fire for their role in the GFC. Here's the Herald with the latest thoughts.

The essential conflict many of these agencies face is described here:

Critics want the cosy club inhabited by the three big credit ratings agencies to be replaced by a system with more accountability to investors, and less crippling conflicts of interest.

So what can be done to fix the credit rating agencies, seen by many as the unsung villains of the crisis?

Some suggestions include holding the firms responsible for their opinions in the courts, breaking up the oligopoly, and cutting investors' reliance on ratings. None is foolproof but each attempts to address the conflict of interest that was brutally exposed by the credit crisis.

A credit rating from one of the big three firms is virtually indispensable for companies looking to raise debt on the market. But it is now clear the incentives in the current system were skewed to encourage agencies to provide as many ratings as possible, at the expense of good advice.

For decades issuers have paid for the ratings because they need them most, and it has been in the agencies' interest to approve as many ratings as possible. However, the Bank for International Settlements says growth in structured finance - complex bundles of corporate debt - created huge systemic risks for this arrangement.

More reform pushes for credit rating agencies

And they need it, too. Though to say that they 'caused' the GFC is attributing a bit too much blame, I think.

Richard Glayas in the Oz.

Regulating the ratings agencies

Well, that's the proposal, anyway. John Durie isn't convinced. Here's what he sees as the nub of the issue:

The real problem is the inherent conflict of interest in the rating agency model, because the person who wants the rating pays for it.

In the midst of the inquiries into ratings industry, according to The Economist, emails were discovered where one analyst, when asked why he was rating a bit of toilet paper, replied: "We rate everything, even if it is structured by cows we rate it."

If someone will pay you to rate their paper and that's your business, then you rate it.

Bank provisioning

One way that banks respond to changes in economic circumstances is via the level of provisioning. It's been interesting to see how the Australian banks have adjusted their level of provisioning in response to the Global Financial Crisis (TM). Here's an article by Richard Gluyas in The Oz focusing on the Commonwealth Bank.

Key graf:

But not only that, Mr Williams said CBA's provisioning coverage was "lacking" compared to its peers. Total provisions as a proportion of risk-weighted assets was only 0.77 per cent, compared to 1.27 per cent for ANZ, 1.11 per cent for Westpac and 0.86 per cent for NAB. "Should, as we anticipate, the environment continues to deteriorate, this will likely result in higher provisioning charges in the near term," Mr Williams said. The bar had been lifted on capital adequacy, Citi said, and CBA was at risk of "not measuring up".

Bond ratings

Here's a nice NYT article on the (failure of) the bond rating agencies. [H/T: Finance clippings]

LTCM

A reminder about what can go wrong, even when smart people are involved. A New York Times essay on Long Term Capital Management.

Sub-prime stupidity

Dennis Berman in the Wall Street Journal calls it like it is.

The subprime realm has thus become a vital portal onto Wall Street, helping us understand just how upside-down the place has become. In this world, risk management is applied retroactively. CEO succession planning is, too.

Don't let those on Wall Street fool you by saying "this is the natural cycle of things." Does it really have to be? Unlike virtually any other industry, Wall Street shakes, twists, and hammers on its innovations until they break. What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?

Credit rating agencies / subprime / Citigroup

Still more on credit ratings. Turns out the mathematical models used by banks such as Citigroup to value securities like the securitized (sic) subprime mortgages (CDOs, or collateralised debt obligations) relies heavily on credit ratings. That led to the situation where (as we've discussed in class) a downgrade by a ratings agency becomes somewhat self-fulfilling. Wall Street Journal "Heard on the Street" article (via the Oz) here . [Note: this is one of the early benefits of News Corp buying Dow Jones. The Australian gets access to the Wall Street Journal. Goodbye AFR?

Collateralised debt obligations (CDOs)

Trying to understand how some of these new fancy financial instruments work? Here's a paper that tries to explain one of the newer things on our radar; the collateralised debt obligation, or CDO. SSRN link here.

From the paper's abstract:

Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.

In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.

Credit crunch losses

Looks like the losses on the recent 'credit crunch' have topped US$18 billion, according to a report in the Financial Times section of The Australian (link). Most of the major banks in the U.S. are reporting write-downs in the value of their loans. It will be interesting to have a look at the reports of these companies to see how they have gone about the valuation of their loans.

I wonder if things would have been different if the U.S banks had to file half-yearly (as in Australia) rather than quarterly. In particular, I wonder if the banks would have disclosed to the ASX the extent of their write-downs under the Continuous Disclosure obligations.

Greenspan slams credit rating agencies

WSJ Online link.

Strategy, financial analysis, credit crunch, and TPI

TPI's recent strategy has been driven by acquisitions. At the end of this year TPI have to refinance about $2.7bn of debt. Given recent events in the credit market, this could prove interesting. More from Adele Ferguson here. Key quote that backs up what we keep discussing in class:

The ride has been exciting, with the share price going on a roller-coaster ride, and profits going through the roof. But analysing a company that makes a lot of acquisitions is tough, particularly one that has reclassified some of its businesses into different divisions and created new divisions.

Credit analysis

More discussion about the potential problems with relying on credit ratings agencies. Lawrence Summers argues:

There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for ratings and shop for the highest.

But there is no room for doubt that the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings?

Credit ratings - worth the paper?

Are the credit rating agencies doing their job well? Stephen Ellis, in discussing the 'sub-prime' mortgage market in The Australian, thinks not. Key quote:

And although S&P and Moody's seem to have been the victims of at least some fraudulent misrepresentation of mortgage quality by originating lenders, it seems fair to ask why they were not checking this information in the first place, given sub-prime mortgages were a startling 20 per cent of the entire US home mortgage market last year.