Review on credit rating system

The causes for the subprime mortgage bubble are complicated, including excessive liquidity, lax supervision on off-balance vehicles like notorious SIVs and conduits, over-consumption in U.S. Yet, many institutional investors have rules to bar them from buying securities that do not carry investment-grade ratings. Without the blessing from major credit rating agencies as safe investments, different investors around the world could not engage into those complex structured finance products.

Much blame is being heaped on the rating agencies regarding their independence and objectivity after subprime woes worsens into full-blown crisis. The credit rating agencies have been heavily criticized due to their own multiple roles. In recent years, credit rating agencies strive to explore the opportunities in ancillary business consulting and risk management advisory services, in addition to its core credit rating business. The revenue contribution from its ancillary business grows on solid footing and has gradually occupied a larger share in total revenue. In addition, incomes from the charges against issuers are on an upward trend. Historically, the vast majority of the revenue for the rating agencies is associated with the subscription fees paid by investors and other credit ratings users. As the cost of rate assessment raced up along with the increased complexity of investment products, rating agencies started to charge issuers for ratings. Arguably, conflict of interest could induce rating agencies to rate liberally and give a "thumbs up" rating to their prime customers.

However, the risk of a meltdown of the credit rating system due to conflict of interest is yet to be substantial. The fees received from individual issuers are still a relatively thin portion of their total revenue, so the risk of compromising on independence and objectivity of analysts due to significant economic influence of single customer would be limited. Most importantly, the rating agencies should fully recognize the importance of issuing credible and reliable ratings for their business. It is not expected credit rating agencies will jeopardize their reputation by allowing issuers to cast influence over their ratings. The question about whether the existence of potential conflict of interest would distort the objectivity of rating assessment remains unanswered, despite out-break of crisis has proved their credit rating models are not sophisticated enough to predict the risk embedded in different credit derivatives.

The barriers to entry and growth into a substantial presence in the rating industry could be a bigger concern for the regulators. Theoretically, the barrier to entry the business as credit rating agency is insignificant. Individuals who meet the capital requirement by local regulatory authorities can publish credit rating reports to worldwide audience on their own will. But seldom will market participants rely upon ratings from second-tier rating agencies as a proxy for credit quality in practice. New entrants are often reported to face difficulties in acquiring the designation of Nationally Recognized Statistical Rating Organization, a national recognition. Only five organizations are currently designated as NRSROs, with Standard and Poor's and Moody's market share reached 80 percent. Market surveillance brought forth by competition has been limited because of the monopoly power leading credit rating agencies wield. A review of the current credit rating system was already underway at the white house. The credit rating system is expected to undergo a process of improvement parallel with the reform suggested by U.S. Treasury Department.

Lack of transparency over ratings methodologies and procedures is of concern also. Albeit rating agencies do not possess statutory authority to access nonpublic information for the purpose of analysis, issuers will commonly provide rating agencies with nonpublic information such as internal capital allocations and budget forecasts, in face of the threat of credit-rating downgrade and ceasing rating activity. Without the disclosure of the application of nonpublic information, credit rating users could hardly determine whether nonpublic information has been included in rating process. As a result, investors can only place the utmost reliance on the ratings and set the stage for systematic collapse. It is understandable that rate assessment is more or less opaque in nature, in order to prevent issuers from manipulating certain financial indicators tracked by rating agencies. Still, rating agencies has responsibility to ensure users to understand how a specific rating was determined by credit rating agencies. In essence, rating agencies would be highly encouraged to offer additional information regarding the reasoning, assumption and underlying risks beyond the rating decision.

Balance between market bailouts and moral hazard

Credit market conditions deteriorated rapidly as 2008 unfolds. U.K. Treasury has announced to nationalize troubled mortgage lender Northern Rock PLC, and Carlyle Capital collapsed after failing to find financing deal with lenders. Last month, JP Morgan said it would acquire its rival Bear Stearns, smoothed by Federal Reserve's funding. Rumors swirled through the market that beleaguered financial institutions were collapsing in midst of the ever-worsening subprime crisis.

Indeed, the Fed has created various new lending facilities apace to stem the credit crunch. A new Term Auction Facility (TAF) announced by the Fed offered term loan to depository institutions eligible for discount window borrowing, up to $100 billion. A new Term Securities Lending Facility (TSLF) announced by mid-March, which secured for a term by a pledge of broader array of securities, including Agency MBS and non-Agency AAA-rated private label RMBS. The Fed also established the Primary Credit Dealer Facility (PCDF) at the same day as JP Morgan announced its acquisition plan. That rewrote the rule book by extending the discount window directly to primary dealers. And even more controversial, acceptance of subprime-related products as collateral under TSLF was blamed as nationalizing the bad debt and bailing out those imprudent investment houses by taxpayers’ money. Conservatives have every reason to feel worry that it may set a dangerous precedent for future risky behavior by other investment houses.

To be sure, maintaining financial stability is the primary responsibility of central banks and no caveat will get in the way to that priority. Whilst central bankers must be involved in the management and resolution of financial crises, the instruments employed should be designed to minimize moral hazard. One must aware the objective of the introduction of TAF is to allow financial intermediaries to foster the liquidity of the banking system by lending highly-liquid Treasury securities with a pledge of less liquid, but high quality mortgage securities. The assets submitted in exchange for Treasuries will be valued at market prices and a 'haircut' is applied to them. The values of collaterals are ultimately dependent on market, although the amount of the haircut applied would inevitably weigh on market sentiment in certain extent. The extension of lending facility aimed to provide a platform for the assets to be managed on a long-term basis, rather than assigning the floor price for those risky assets. Ironically enough, as counterparties of Bear Stearns were not convinced that the central bank has assigned the floor value for the assets on Bear's book, massive cash withdrawal was reported on later sessions and eventually led to the collapse of the Wall Street's fifth-largest investment bank.

Should the Fed just let Bear to go bankruptcy and liquidate its asset to meet the obligations? The damage caused by a default by Bear could have been severe and difficult to contain. Tighter credit standards lead to lenders to sell assets for a small fraction of its book value, forcing down the asset prices and triggering the margin call. Borrowers need to unload the assets to meet the call, adding to the air of crisis. The downward spiral could lead to panicky price movements and the effect of rate cut would be weakened by widening credit spread. Another way to stop a bank run is nationalizing Bear Stearns like Britian's bailout of Northern Rock bank, and accepting the moral hazard in return.

Unlike the Bank of England, the New York Federal Reserve Bank opted to facilitate the acquisition of JP Morgan with emergency fund and left the financial conglomerate at the discretion to determine the residual value of Bear Stearns. As equity holders in Bear Stearns have essentially been wiped out, such measure helps curbing the expectation that central bank already implicitly offers insurance policies beyond guarantees for borrowers and reduces the probability of distorting risk taking. Nonetheless, the Fed has to bear the risk that a stunningly low price may spark the panic the investment banks are already bankrupt. In hindsight, the Fed has struck a proper balance between limiting moral hazard and ensuring stability during the financial crisis. While clamor grows for more central bank intervention in the modern financial system, as demonstrated by the case of Bear's bailout, different factors have to be duly examined before the central bankers step in battling the financial turmoil. The growing desire for intervention must be tempered with caution.

Pros and Cons of emboldened rate movements

The traditional deposit/loan business can no longer be a bright spot to raise investors’ eyebrow in the past few years. The financial wizardry finds a way to make big profit by repackaging illiquid assets to marketable securities. But far and away the greatest damage from all this financial wizardry is not repackaging assets per se, but the unsustainable capital structure lulled by derivatives bubble. Intrigued by the lion profit in the credit derivatives market, financial firms used extensive borrowing to buy credit derivatives and assumed more risk. Financial institutes fund significant portions of their balance on short term basis through the repurchase market, which is extremely vulnerable to de-leveraging and a sudden pullback in the short-term credit market. The emboldened rate move of the central bank is expected to motivate financial institutions to alter their highly leveraged capital structure. The Fed has already lowered its benchmark interest rate from 5.25% to 2.25%, and investors widely call for further rate cut in the second quarter. Short-term interest rates slashed after Fed's aggressive rate moves, and long-term rates remained barely unchanged in response to elevating inflationary pressure. A steepening yield curve would induce banks to recapture the profit opportunities of traditional deposit/loan business, and hence improve their capital structures.

Yet, the risk of the financial market greased with low interest rates should not be neglected. The Fed slashed interest rates aggressively to lean against the headwind of dotcom bubble burst and 9.11 event during the Greenspan Era. The seeds of today's disaster were sown as central bank injected billions of dollars of liquidity into the banking system. In the same manner, the resulting glut of liquidity from emboldened rate move of central bankers today may eventually lead to another ill-starred boom. And now, speculative bubble in the commodity market has already aroused our attention.

In comparison to stagnant stock and bond markets, investors will not find difficult to figure out the attractiveness of commodity markets. The appetite for commodities as inflation hedging tool increased further after the massive inflow of capital to send commodity prices and inflation higher. According to U.S. Commodity Futures Trading Commission, the aggregate of all long and short open interest hit 2.5 millions at the first week of April. The daily turnover of NYMEX crude oil future market could reach 2.5 billions barrels, almost 30 times to current world oil consumption of 86 million barrels a day. Accordingly, capital engaged in crude oil future market is estimated to stand around 100 -150 USD billions. Though capital involved in commodity market is still considered as a slight portion relative to the market capitalization of stock, foreign exchange and bond markets, but just as epitomized by the subprime fallout, the “butterfly effect” on the entangled financial system due to burst of commodity bubble would be difficult, if not impossible, to estimate. While the worst time of the subprime fallout is yet to pass, it may not be too early to talk about the looming commodity bubble.

Lam Chun Wang
Senior Economist

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