Carlo R.W. de Meijer is senior researcher for Market Infrastructures at ABN AMRO Bank. He has a master�s degree in international economics from the University of Tilburg (1977). During his career, Carlo has occupied various functions within ABN AMRO, both as senior economist and as a private investment adviser. He has published many articles on various economic and financial topics, especially related to international financial markets, and to European financial and monetary integration.

Michelle H.W. Saaf is senior vice president and head of Market Infrastructures Securities at ABN AMRO Bank. She studied law and has a master�s degree in business science and (international) strategic management from Erasmus University Rotterdam School of Economics and Ann Arbor University Michigan, USA. Michelle has broad experience in various management positions. Before she joined ABN AMRO Bank she was senior manager at (NYSE) Euronext and LCH.Clearnet.

ABSTRACT

International discussion is nowadays increasingly dominated by the credit crunch that is negatively impacting not only the financial markets but also the global economy. Though this crisis can (justifiably) be blamed upon all parties involved (deal structurers, banks, investors etc.) a large part of the credit crisis has been blamed on the credit rating agencies (CRAs), that play a vital role in global securities and banking markets. The recent credit crunch and the resulting market turmoil have revealed a number of shortcomings with regard to CRAs� ratings of structured finance products, in particular their credit rating process. CRAs are said to have been too positive on the risky financial products that were issued by US subprime lenders. Both investors and regulators in the US and Europe have criticised the methods used by CRAs that led to upbeat assessments of investments, which turned out to be linked to risky home loans in the US. CRAs have also been criticised for not alerting and/or being too slow to warn investors of the risks of buying US subprime related products. Finally, CRAs are seen as having a conflict of interest because they often provide advice to financial institutions on structuring and also assess and rate their debt and structured products. This has forced both European and US regulators to review the present role and responsibility of CRAs. Some critics urge the need for reforms and are calling for heavier regulation on how CRAs rate structured finance products. Though there are still differences in thoughts about future treatment of credit rating agencies, there is increasing consensus that it makes �no sense� to regulate them on a much stricter basis. Existing financial services directives applicable to CRAs, self-regulation by the CRAs on the basis of a strengthened IOSCO Code of Conduct, combined with market pressure and regulatory review is seen as the most appropriate approach.

Keywords: Credit rating agency, Asset Backed Securities, structured finance products, Code of Conduct, Chinese Walls

INTRODUCTION

International discussion is nowadays increasingly dominated by the credit crunch that is negatively impacting not only the financial markets but also the global economy. This crisis started in the US in the summer of 2007 when customers were not able to pay the interest and payment on their sub prime mortgages following the expiry of their preferential interest rate and the subsequent application of a higher floating rate of interest. As a consequence banks were obliged to write down almost $ 250 billion on their mortgage portfolios and expectations are that this amount will further increase in the coming months. This crisis also manifested on the international exchanges that saw their market value evaporate by $ 5.200 billion in January 2008.¹ Though this crisis can (justifiably) be blamed upon all parties involved (deal structurers, banks, investors etc) a large part of this credit crisis has been blamed on the credit rating agencies (CRAs) who are said to have been too positive on the risky financial products that were issued by US subprime lenders. Critics moreover state that CRAs failed to give sufficient risk warning to investors², forcing both European and US regulators to review the present role and responsibility of CRAs³.

Impact areas of Credit Rating Agencies

CRAs play a vital role in global securities and banking markets. Credit ratings expressing debt quality are used for various purposes. They not only play an important role in the institutional investment process as a reliable assessment of investment risks. A good credit rating might also improve the marketability of issuers. Buy-side firms use these ratings as one of several important inputs to their own internal credit assessments and investment analysis, whereas sell-side firms use ratings for risk management and trading purposes. Regulators also mandate usage of credit ratings in various forms, e.g. in calculating Basel II bank's capital adequacy requirements. The Basel Committee on banking supervision allows banks to use external credit ratings to determine capital allocation (Basel II). Local or national governments might place restrictions on civil service or public employee pension funds. Regulations also require banks, insurance companies and institutional investors to invest only in certain grades of debt.

Main criticism of CRAs

The recent credit crunch and the resulting market turmoil however have revealed a number of shortcomings with regard to CRAs' ratings of structured finance products, in particular their credit rating process. Certainly, CRAs cannot escape the blame for this crisis given their role in endorsing many so-called securitization vehicles that seemed to be far from transparent, making it difficult for investors to assess the risk contained in these products. Both investors and regulators in the US and Europe have criticised the methods used by CRAs that led to upbeat assessments of investments, which turned out to be linked to risky home loans in the US. CRAs have also been criticised for not alerting and/or being too slow to warn investors of the risks of buying US subprime related products. This was highlighted by former Fed president Greenspan who blamed CRAs for being too slow to react on the "subprime mortgage meltdown". According to Greenspan, the CRAs failed to downgrade fast enough the highly (AAA) rated securities backed by subprime mortgage debt. Other critics say that the CRA �business model' is fundamentally flawed. Finally, CRAs are seen as having a conflict of interest because they often provide advice to financial institutions on structuring and also assess and rate their debt and structured products.

In particular:

• Poor credit rating quality: CRAs have been strongly criticised with regard to the accuracy of their ratings for specific structured finance products. This especially involves sub prime residential mortgage backed securities (MBS)⁴. CRAs are being blamed for giving overly optimistic ratings (triple A) to these complex products, signalling to investors that they appear as safe as a US Treasury bond. The biggest casualty has been the universally accepted triple A symbol which until recently conveyed a clear quantitative statement of almost zero probability of loss. But does triple A rating in practice mean the same for bonds and structured products?
• Inadequate models: CRAs were blamed to have used inadequate rating models. CRAs were wrong in assessing the creditworthiness of exotic mortgage-related bonds and other credit derivatives, particularly the parcels of debt known as collateralised debt obligations or CDOs⁵, the very subprime mortgage-backed instruments that are at the basis of the current credit crisis. The CRAs rating models for these structured products proved to be flawed because they not only underestimated the default possibilities but also failed to identify other fundamental risks inherent in these MBS e.g. credit assessment and underwriting criteria. Basically, the problem is that their models rely too heavily on historical data when setting up the ratings for new products such as structured finance, whereas data does not exist for many of these products. According to critics, CRAs have also done nothing in their ratings to distinguish between mortgage paper. Consequently, many now wonder why these (in principle) high risk structured finance debt instruments received the equivalent Triple A rating as US Treasuries, instead of receiving a more riskier rating.
• No early warning: The CRAs were also blamed to have failed to give investors adequate warnings over risks linked to these mortgage backed securities (MBS) through a fair and transparent assessment. They were thereby criticised for being too slow in their reaction to the subprime problems i.e. waiting too long to significantly downgrade these mortgage bonds and related structured products. Though CRAs have admitted these fundamental misjudgements on subprime debt issues, even the possibility that there will be many more downgrades to come is not seen as a sufficient reaction by the CRAs as far as the critics are concerned.
• Conflicts of interest: CRAs are also criticised for fundamental flaws in their funding model. Potential conflicts of interests emanates from how CRAs are getting paid. In the early 1970s CRAs were paid by investors who needed to tap them for their information, so that they could make solid judgements on investment risks. Critics state that in the present credit rating system CRAs are being paid by these institutions that issue structured finance products to give ratings (and not by investors in those products). The big profits of CRAs are thanks to the increased fees of the �structured finance'⁶ products that are seen at the root of the credit crisis. Consequently, critics are now accusing these CRAs of having a (too) close relationship with issuing institutions of the products they rate. The market view is that CRAs are under too much pressure to give their clients a (more) favourable rating for these risky products in exchange for high fees. The vast majority of institutional investors in these products are restricted as to the quality of their investment. These restrictions are invariably expressed in terms of credit ratings, with most investors not being prepared to buy anything that is not �A-rated' or better.

Changing role of CRAs

Credit rating agencies have played a pivotal role in the global debt markets for over thirty years. For most of their history, the CRAs performed the task of applying ratings regarding the creditworthiness of financial instruments and publicly traded companies, and reviewing these ratings if economic or financial circumstances merited. The CRAs letter scale of ratings⁷ reflecting credit quality have formed the basis of the capital markets and are used by investors to make informed investment decisions.

Credit ratings are also written into the regulators rulebooks as the basis for bank capital requirements (Basel II), and dictate how fund managers allocate their assets. In view of this important status, the rating agencies themselves have to be approved by national regulators. In the US for example, an agency must be granted Nationally Recognised Statistical Rating Organisation (NRSRO) status by the Securities and Exchange Commission (SEC).

Much of the recent criticism has to do with the changed role of CRAs in the rating process for structured products and the misunderstanding between investors and CRAs in terms of the scope of ratings. There has been a remarkable shift in the underlying nature of CRAs' work, caused by the boom in structured finance - best described as the repackaging, restructuring and resale of existing debts. This has placed the CRAs in a qualitatively different role that has been extended well beyond that of most information providers. The large CRAs - Moody's, S&P and Fitch - now play a dominant role over the whole spectrum of the credit market. CRAs have thereby become intimately involved in (and an active part of) the issuance process itself, from advising the investment bankers and their clients on structured finance/debt products to publishing the credit ratings for these products. The rating process has thereby become an integral part of the design and financial engineering of these products, in particular for CDOs. From mere intermediaries CRAs have become quasi securitisation regulators. This changing role of CRAs is also mirrored in their funding model. Originally CRAs were compensated by subscriptions paid for by interested investors. CRAs however have changed from an 'investor pay' to an �issuer pay' model, in which the issuers of financial debt products themselves generally pay for rating. The structured finance issuance organisation now pays high fees to bond underwriters and to the rating agencies, creating possible conflicts of interest⁸.

Misunderstanding on ratings

The rating of these structured products however has led to a deep misunderstanding between investors and CRAs. First of all there is confusion surrounding the actual scope of the rating. CRAs consider themselves responsible for solely assessing credit risk, reflecting both the likelihood of default and the probability of a financial loss suffered in the event of default, while many fund managers may have expected that ratings would cover all the risks (notably liquidity risk) that weigh on their investments. A second source of misunderstanding stems from the metric used for rating structured products. The CRAs expressed -- on multiple occasions -- that their credit assessment metrics were designed for consistency "across asset classes". But why did they insist on applying the same ratings for the CDOs as they did for regular debt obligations when the nature of the credit is so different? The consequences of assigning a triple A rating to a CDO⁹ and to a corporate bond are not the same as the risk profile is different. Structured finance product ratings differ from the ratings of corporates as these products are built on correlations and leverage. The rating of a structured product is not an average of the ratings of the underlying assets. It depends on both the correlation between the yield on the various securities and the leverage effect embedded in the structure. The potential volatility of a Triple A rating for a structured product in particular is therefore far greater than a AAA rating for a traditional plain vanilla product.

Towards a new model of mortgage lending

The deeper cause of the present credit crunch has much to do with the sophistication and complexity of how banks nowadays sell mortgages. With respect to CRAs' ratings, investors are now questioning the real value of several new types of securities that in turn had been used as collateral for outstanding mortgage loans. Regarding the mortgage market, banking has fundamentally changed from a culture of �protection' (of deposits) to an entirely new model of �structured finance'. The normal practice of banks who sell mortgages to hold these until maturity is over, has changed to a model where they sell on the mortgages to the bond markets.

Many of these mortgages are now converted into complex financial instruments via a process of securitisation whereby mortgages¹⁰ have been packaged into a group of mortgages, then repackaged in a collateralised debt obligation and finally sold through their �off balance' sheet operations on the bond markets to, inter alia, pension funds, mutual funds and hedge funds that bought it on leverage. This has made it much easier to fund additional borrowing and has proved extremely profitable for the banks. The bottom line, however, is that the banks no longer carry mortgages or the risk; they basically act as conduits. In the 1980s when there was a mortgage default, it was the bank that took the risk. Now it is the (global) market that carries the risk.

Regulatory perspective

US federal and European regulators are now examining the role that CRAs have played in the present credit crisis. IOSCO, the International Organisation of Securities Commissions¹¹, is discussing a coordinated regulatory response to the CRAs failings, while the European Commission and the US SEC (Securities and Exchange Commission) are pursuing parallel inquiries. Credit rating agencies are now being carefully scrutinised and are being reviewed on their objectivity and performance in the wake of the credit crisis. They have expressed their worries about the "oligopolistic nature" of the market, the slow reactions of the CRAs to changes in the market conditions and the absence of independence to the companies they rate. Some critics urge the need for reforms and are calling for heavier regulation on how CRAs rate structured finance products.

IOSCO

IOSCO, is now reviewing¹² the roles and duties of CRAs to identify the implications for securities regulators of the subprime crisis. The focus is on the following questions: Have CRAs played their role in a appropriate way and should they (IOSCO) do something in tandem with the CRAs to clarify the methodologies and the meaning of the ratings? A special Task Force of IOSCO¹³ is therefore reviewing its existing Code of Conduct Fundamentals for CRAs, a globally accepted industry standard, to reduce conflicts of interest and increase transparency in the industry. Part of their review process is to ensure that the CRAs have a sufficient standard of objectivity and that the ratings do conform to the default experience of the securities. The Task Force published its final conclusions end May 2008.

According to IOSCO, lawmakers should avoid over-regulation of CRAs. They should be given a chance to put their own house in order instead of more regulation. Nevertheless the Task Force wants to see significant reforms in the way international CRAs conduct business. The IOSCO Code will therefore have to be supplemented and their procedures adopted by the CRAs. Various possible advancements in the model IOSCO Code of Conduct Fundamentals for CRAs are being discussed. The Task Force's proposals, include: improving the disclosure of the assumptions underlying the individual ratings for structured finance transactions and improving the quality of information used to support a credible rating; prohibiting the ratings agencies from offering advice on the design of structured products, which an agency also rates, in order to remove conflicts of interest; a call for CRAs to distinguish structured product ratings from corporate ratings and improve their processes; and introducing a separate ratings category that distinguishes structured product ratings from both corporate and commercial paper ratings. The Task Force also considered if it is appropriate for CRAs to shift from a focus on credit solvency to a more global approach, including liquidity risk.

SEC

The SEC, the US Securities and Exchange Commission, also started a review¹⁴ of the CRAs' business practices, which will examine the role of credit rating agencies in the structured finance market (incl. MBS) and review the overall policy relating to the role CRAs have played in the subprime debacle. In detail they are investigating the role of CRAs in lending practices, how their ratings are being used and how securitisation - i.e. repackaging and selling of assets - has changed the mortgage industry and related market practices. Part of this review process is intended to guarantee that CRAs have a sufficient degree of objectivity and that the ratings are in accordance with the �default experience' of the assets.

Through this review process, the SEC aims to improve disclosures and push greater transparency in market evaluation of any rating. This should be realised, among others, by requiring rating agencies to provide information regarding past rating performance and the accuracy of previously assigned ratings. The SEC is also considering new rules aimed at enhancing investor understanding of important differences between ratings for municipal and corporate debt and for structured debt instruments. The US Securities and Exchange Commission expects to formally propose new rules concerning CRAs in June 2008.

CESR

On request of the European Commission, CESR, the Committee of European Securities Regulators, started a consultation process at the end of 2007 to review the role of credit rating agencies in structured finance. Though CESR left open the question as to whether more regulation should be implemented, it has provided a cost benefit analysis associated with the current regulatory regime and a possible formal regulatory regime. The main areas covered in this document are: transparency of rating processes and methodologies; monitoring of rating performance; CRA staff resourcing and conflicts of interest. CESR has come up with a number of suggestions for enhanced transparency of the credit ratings process and properly managing conflicts of interest. These suggestions include: clearer and better targeted communication; improvements in monitoring of ratings; greater disclosure of the fee structure; clearer guidelines on interaction of CRAs with issuers and arrangers of structured products; and clear guidelines on the services to be considered core and ancillary. CESR published its final report to the European Commission on 19th May 2008¹⁵.

ESME

In parallel to the CESR request, the European Markets Expert Group (ESME), was also given a mandate¹⁶ in November 2007 to advise the European Commission on certain issues concerning the role of credit rating agencies and the importance of ratings in the financial markets, in particular in the field of structured finance. This advice due by the end of May 2008 will be used by the Commission to complete its own assessment of the CRAs' activities and their role in the recent credit crisis. ESMEs focus will be on specific issues including, inter alia, the oligopolistic market structure, quality of ratings, robustness of rating methodologies, transparency of rating methods, structured finance ratings versus corporate ratings, transparency regarding rating changes, surveillance of existing ratings and to provide its views for improvement of the rating process in respect of all of these issues.

No regulatory intervention

The above mentioned reviews have identified a number of shortcomings of CRAs to comply with the self-regulatory IOSCO Code of Conduct. Though there are still differences in thoughts about future treatment of credit rating agencies, there is increasing consensus that it makes �no sense' to regulate them on a much stricter basis¹⁷. According to some it is seen as more of a learning process for the industry as a whole, rather than a case of market failure of the Code. Existing financial services directives applicable to CRAs, self-regulation by the CRAs on the basis of a strengthened IOSCO Code of Conduct, combined with market pressure and regulatory review is seen as the most appropriate approach.

What measures should be taken?

It is clear that most parties involved wish to avoid any rush into too stringent regulation of the CRAs. However, just implementing some minor changes to the existing system is not seen as enough. EU leaders have therefore agreed to step up efforts to improve transparency, coordinate national regulators, review the role of CRAs and strengthen management of liquidity risks. To restore investors confidence, it is essential that CRAs consistently provide ratings which are independent, objective and of high quality. There is now broad consensus on a number of possible improvements.

A raft of proposals were given by the various involved parties, which are focused less on increasing competition, and more on increasing accountability, consistency, quality and improved transparency in the rating process. These proposals include greater transparency of rating methods and the overall role of CRAs in the securitisation process, given the complexity of structured investment pools; a marked difference in the metric used for rating bonds and structured products, which would restore confidence in ratings¹⁸; and a specific rating for liquidity risk. Other proposed measures include a change in their funding model and disclosure requirements relating to conflicts of interest.

More transparent rating process

The rating process should become more transparent. For that purpose CRAs must make public the basis for their ratings, including performance measurement statistics, historical downgrades and default rates. CRAs should also disclose their procedures and methodologies for assigning ratings. This in order to protect investors and enhance the reliability of credit ratings.

But also the transparency in the information content of credit ratings should be improved, to increase investor's understanding of the risks associated with structured products. For that CRAs should not just restrict their role to assessing credit worthiness of issuers. CRAs should also disclose material risks they uncover, during the risk rating process, or any risk that seems to be inadequately addressed in public disclosures, to the concerned regulatory authority for further action.

Unveil their conflicts of interest:

1.   Chinese Walls
To reduce possible conflicts of interest Chinese Walls should be implemented between the credit rating activities and the ancillary business.

2.   Reform of CRAs business model
Some plead for a system whereby the interests of the investor and the CRA run in parallel. To achieve this approach, CRAs should develop a new funding model that is not dominated by issuers fees but where CRAs are paid by debt issuing institutions (sellers of securities) as well as investors. It will be a challenge to find ways in which a rating agency is compensated for the quality of work they perform. However, such an approach will prevent distortion of the structured product markets and potential market failures.

3.   Disclosure Requirements
CRAs have admitted the possibility of conflicts of interest in their �business model' when delivering their rating services. They have also indicated that strict measures have been taken to prevent such a conflict of interest. It is to be expected that investors should receive a �conflict-of-interest' disclosure at every rating. The so-called disclosure requirements of the Rating Agency Act should help users of credit ratings to assess the reliability of ratings through time and should also increase transparency with regard to the accuracy of CRAs ratings.

Reactions by CRAs
The CRAs themselves are also going through a period of self-review and have embarked on efforts to restore their shattered reputations. Pressure for change from regulators in both Europe and the United States has triggered a defensive posture by the CRAs who are trying to parry criticism by explaining their role and at the same time crystallising efforts to reform their processes.

Explaining the role of CRAs

According to the CRAs, much of the criticism they have received is based on a lack of real understanding of their roles and the meaning respectively scope of their ratings. The rating industry has already started to warn investors and/or asset managers that there is need to rethink the way they use these ratings. CRAs also say that credit ratings are increasingly used out of context. Too many investors have relied on ratings as a �quality label'.

According to the CRAs, they only publish opinions on creditworthiness, the credit ratings just being a means to determine the risk and to differentiate the credit quality. The CRAs further maintain that ratings just give an estimation of the likelihood of the occurrence of a default in the future and is no recommendation (to buy, sell hold a certain debt), endorsement or guarantee of investment. Furthermore, a rating does not represent a rating of the potential performance of the individual structured product itself nor does it comment on the market liquidity of a debt instrument, its market value or its price volatility.

Reform the CRA processes

Rating agencies are now also reviewing their procedures. The three big CRAs - S&P, Moody's and Fitch - recently provided various proposals in a response to the widespread criticism about the quality and accuracy of their credit ratings. In particular they are reviewing their methodologies and taking steps to guarantee that the ratings and the assumptions underlying these are analytically sound in the light of changing circumstances. They are also seeking to counter criticism that they face conflicts of interest by creating plans to appoint advisory boards and to separate sales teams from credit analysis.

1.   S&P
S&P has announced a 27 step plan¹⁹ aimed at strengthening the ratings process and bolstering confidence in credit ratings. The plan will provide the public with greater understanding of ratings and minimise perceived conflicts of interest. It should also enhance independence, strengthen the rating process and increase transparency. S&P also proposes, inter alia, to: establish an ombudsman who would look at these potential conflicts; engage an outside company to review compliance and governance processes periodically; rotate lead analysts periodically; review their work if an analyst leaves the company to work for an issuer; and create a user manual and investor guidelines for credit ratings. S&P also plans to change the methodology which it uses to rate structured products. In terms of analytics, S&P intends to highlight additional factors that are not (yet) covered by traditional default ratings like liquidity, volatility, correlation and recovery.

2.   Moody's
Moody's is also taking the necessary steps²⁰ and has responded to its critics by publishing five proposals for improving the rating process. The specific aim of Moody's proposed reforms is to give investors more information, both about the products they are buying and about the way the CRA came up with its credit rating. Warnings could include a volatility rating, signaling how likely it was that the creditworthiness of the product could be revised down, or even a quality indicator to reflect the quality and complexity of the data underlying Moody's assumptions. These proposals also include the introduction of a new rating system for complex debt securities. This would distinguish a structured security, such as CDOs, from a corporate or government debt. It involves a completely new rating scale for these products, assigning numeral grades to structured securities ranking from 1-21, rather than its customary letters. Next to that, Moody's is separating its credit ratings operations from its marketing and analytics.

3.   Fitch
Fitch has provided investors with various proposals to change its rating methodology for corporate CDOs. Fitch anticipates that the final criteria will be issued no later than the end of March 2008, at which point the agency will recommence issuing ratings for corporate CDOs. Fitch's proposed revisions to its corporate CDO methodology are designed to provide an updated, more forward-looking view of corporate default and loss experience. The intention is to produce CDO ratings that perform similarly in terms of default risk and ratings migration with the market's expectation for other asset classes. This is particularly true for 'AAA' and other highly rated CDO tranches.

CRAs and Compliance requirements

CRAs are required to fully incorporate the IOSCO Code of Conduct into their own procedures. To guarantee compliance of CRAs there is a disclosure mechanism to monitor compliance at the heart of the existing IOSCO Code: Credit rating agencies have to disclose how they implement the various provisions of the Code. Nevertheless, present compliance of CRAs with the IOSCO Code of Conduct is unsatisfactory. The present IOSCO approach offers a �degree of flexibility' to CRAs, which may vary considerably in size, business model, and development of the markets in which they operate. It is also designed to allow investors, issuers, regulators and other market participants to assess in each case whether a given credit rating agency has implemented the IOSCO Code to their satisfaction, and react accordingly.

In the European area the European Commission monitors the credit rating agencies' compliance with applicable EU directives and the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. In this respect, the Commission intends to gauge the opinions of market participants, and especially those purchasing complex financial instruments, by requesting advice of the group on specific issues related to the regulation of CRAs. The European Commission has formally requested the Committee of European Securities Regulators (CESR) to monitor CRAs compliance with the IOSCO Code of Conduct and to report back to it, on the assessment of CRAs' compliance of the IOSCO Code on an annual basis.

Notwithstanding the many critics on CRAs and on their level of compliance, there is still general consensus that compliance will be best achieved through market mechanisms and appropriate appeal and complaint procedures built into rating agencies' own codes of conduct. To satisfy and/or enforce compliance requirements of CRAs various suggestions are being made. The newly proposed IOSCO Code Fundamentals offer a set of robust, practical measures that should serve as a guide to and a framework for implementing the Principles' objectives. These measures are the fundamentals which should be included in individual CRA codes of conduct, and the elements contained in the Code Fundamentals should receive the full support of CRA management and be backed by thorough compliance and enforcement mechanisms. In order to strengthen the process the newly proposed IOSCO Code of Conduct likes to see CRAs to appoint an executive-level compliance officer position at CRAs to ensure implementation and enforcement of the IOSCO Code and to ensure compliance with other applicable securities laws and regulations.

CONCLUSION

The general consensus of opinion is that there is no case for a large scale overhaul as originally bandied about by financial "experts" in the early days of the credit crunch. Regulators have, however, put CRAs on notice that things cannot stay the same. The CRAs, being blamed for "having got it so wrong", may therefore prove unable "to survive in their current form". EU leaders have agreed to step up efforts to improve transparency, coordinate national regulators, review the role of CRAs and strengthen management of liquidity risks. To restore investors confidence, it is essential that CRAs consistently provide ratings which are independent, objective and of high quality. The financial industry as a whole should also exert more self control, demanding improvement of risk management at all levels. Regulators are now shifting their focus to how they can reduce the dominant role of ratings in the banking regulatory system.

There are clear �limitations' to the use of credit ratings as a proxy for objective standards of monitoring risk. Notwithstanding the above, rating agencies are undertaking their own reforms and ratings will remain an important part of the process simply because all investors cannot be expected to do their own thorough due diligence on every security. CRAs are, however, unlikely to be as singularly dominant as they have been in some markets for the past 30 years. While credit ratings can be good indicators as to the performance, risk and relative safety of products over a period of time, they must not be considered as the sole guide for selecting one's investments.

Note:
Any opinions expressed in this paper are those of the authors and do not necessarily represent the policies or opinions of ABN AMRO Bank.

Reading list

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Future path for the Rating Agencies? - SEC considering changes to the rating process, February 17th, 2008 (http://mortgagenewsclips.com/2008/02/17/future-path-for-the-rating-agencies-sec-considering-changes-to-the-rating-process/)

P. Jackson, (February 15, 2008), SEC looking to revamp role of rating agencies amid mortgage mess (http://refinance-free-credit.com/2008/02/15/sec-looking-to-revamp-role-of-rating-agencies-amid-mortgage-mess/)

Tempus Advisors, (February 13, 2008), The ongoing credit crunch: What's next for structured finance, credit rating agencies and bond issuers (http://caps.fool.com/Blogs/ViewPost.aspx?bpid=34303&t=01000000000103882559)

CMSA, EACB, EBF, (8 February 2008), Summary of European industry commitments to the European Commission regarding transparency in the European Securitisation Market (www.esbg.eu/uploadedFiles/Position_papers/0133.pdf)

Dennis P. Lockhart, Federal Reserve Bank of Atlanta, February 7, 2008, Thoughts on the future of credit markets (http://www.frbatlanta.org/invoke.cfm?objectid=F400D2BA-5056-9F12-12C1F5156DCBB7A3&method=display)

Mark Noble, (February 06, 2008), Calls for credit rating agency reform grow (http://www.advisor.ca/news/article.jsp?content=20080206_143835_5972)

Alex Wallenwein, (Feb 06, 2008), The coming collapse of international credit ratings agencies - Moody's, Standard & Poor, and Fitch (http://www.marketoracle.co.uk/Article3625.html)

Paul Amery, (06.02.2008), The great credit rating scandal (http://www.moneyweek.com/file/41822/the-great-credit-rating-scandal.html)

P. Jackson, ASF update, (February 05, 2008), Rating Agencies take a beating (http://refinance-free-credit.com/2008/02/05/asf-update-rating-agencies-take-a-beating-2/)

Marcin Grajewski (Jan 14, 2008), Rating agencies defend role in subprime crisis (http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSBRU00622820080114)

Hew Jones, France (14 January 2008), EU regulator says no ruling yet on rating agencies (http://www.reuters.com/article/companyNews/idUSN1442322720080114)

Larry McDonald (November 20, 2007), Credit ratings agencies role in subprime creation, (http://seekingalpha.com/article/54798-credit-ratings-agencies-role-in-subprime-creation)

Jonathan S. Sack and Stephen M. Jris, New York Law Journal (November 5, 2007), Rating agencies: civil liability past and future (www.magislaw.com/Articles/07011070002Morvillo.pdf)

BBC News (14 September 2007), Darling censures rating agencies (http://news.bbc.co.uk/2/hi/business/6995699.stm)

Suzy Jagger, Times Online, (September 6, 2007), Credit rating agencies come under spotlight as US mortgage turmoil spreads (http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2395505.ece)

Standard & Poors (August 23, 2007), The fundamentals of Structured Finance Ratings (www2.standardandpoors.com/spf/pdf/media/082307_ian_op_ed_brt.pdf -)

BIS (January 2005), The role of ratings in structured finance: issues and implications, Committee on the Global Financial System (http://www.bis.org/publ/cgfs23.htm)

References

1. Both in Europe and the US, CRAs are the butt of criticism from regulators, politicians and investors alike. CRAs have been criticised by France (Sarkozy), Germany (Merkel), UK (Brown) and the European Commission (McCreevy) at the Credit Crunch summit of European Leaders in London, 29 January 2008. Mr. Sarkozy said: "The warnings we are issuing to credit rating agencies have to be heeded". German chancellor Angela Merkel joined the chorus of critics, saying: "It is not acceptable that wrong risk assessment in one place has to be paid for by the entire global community." Gordon Brown, the UK Prime Minister advised, "We need a better early warning system for the global economy".

2. "Standard & Poor's, the world's leading index provider, announced that world equity markets lost a combined $5.2 trillion in January as emerging markets fell 12.44% and developed markets lost 7.83% to register one of the worst ever starts to a new year.", World Equity Markets lost $5.2 trillion in January, By Finfacts Team, Feb 9, 2008 (http://www.finfacts.ie/irishfinancenews/article_1012536.shtml)

3. Reviews on Credit Rating Agencies are being executed by e.g. IOSCO (International Organisation of Securites Commissions), SEC (US Securities and Exchange Commission), CESR (Committee of European Securities Regulators) and ESME (European Markets Expert Group)

4. Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

5. CDOs are new structured investment instruments that are extremely complex. What happens is that investment banks sell interests in a pool of mortgages. The value of the underlying bonds is derived from the expected future cash flow from the mortgages that make up the bond. When these bonds are packaged together, a certain percentage of the underlying mortgages is expected to default and end up in foreclosure. The pool of mortgages is divided up into groups called tranches; each tranche corresponds to different levels of risk and reward. The highest rated tranches have the highest priority for repayment of principal, and the lowest interest rate offered, while the lowest rated tranches have the lowest priority for repayment of principal but the highest rate of interest offered.

6. Structured finance products are synthetic investments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets.

7. From Triple A to C

8. In practice, however, the investors and the marketplace that have set up this conflict of interest, not the CRAs and the issuers. This in order to save costs. Thus, the third party payer problem is triggered in the rating system; issuers--who are known to the CRA--pay for the product, but the CRA somehow owes a duty to a group of nebulous "future investors".

9. Of all asset classes, CDOs are those whose rating is the least stable over time

10. But also loans of every type like lease, credit cards etc.

11. IOSCO, the International Organisation of Securities Commissions, the world's top group of market regulators.

12. Final Report IOSCO: "The Role of Credit Rating Agencies in Structured Finance Markets", May 2008 (http://www.iosco.org/library/index.cfm?section=pubdocs)

13. Existing of representatives from global regulators, finance ministers and central bankers

14. Sidup Kar-Gupta: "SEC probing main credit rating agencies"26th May 2008 (http://news.yahoo.com/s/nm/20080526/bs_nm/sec_moodys_dc&printer=1;_ylt=AvuG...)

15. CESR: (Second Report to the European Commission on the Compliance of Credit Rating Agencies with the IOSCO Code and the Role of Credit Rating Agencies in Structured Finance" 19th May 2008 (http://www.cesr-en.org/index.php?page=groups&mac=0&id=43)

16. European Commission: "Mandate to ESME for advice: Role of Credit Rating Agencies" 28th November 2007 (http://ec.europe.eu/internal_market/securities/esme/index_eu.htm)

17. CESR Chairman Wymeersch: "We should give a chance to rating agencies to put their house in order"; German Finance Minister Steinbeck: "It made no sense to regulate them" January 2008; ECB President Jean-Claude Trichet: "This did not mean that a dramatic change in rules were needed or that too much regulation to put in place" 22 November 2007 and European Commissioner Charlie McCreevy: "Wanted to give the (IOSCO) Code time to prove itself" 16 August 2007

18. Either by adopting another rating scale for structured products; or by including an additional measure in the credit rating in particular on its volatility in times of market or liquidity stress

19. Herald Tribune: "S&P overhauls ratings process in wake of subprime news" February 7, 2008 (http://www.iht.com/articles/2008/02/07/business/ratings.php)

20. Michael Mackenzie, New York (February 8, 2008), Rating agencies struggle to make the grade (http://us.ft.com/ftgateway/superpage.ft?news_id=fto020820081105027366)

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