The latest wave of proposed European regulations on rating agencies, known as CRA3, contains a rule that has unsettled players from every corner of the financial market: enforced ratings rotation.
That is, an issuer would have to periodically change the agencies that rate it or a given deal according to a set timetable. Depending on the maturity of a transaction and other factors, as many as six agencies might be needed to rate a single deal over its life.
Financial sector pros argue that the proposal would generate any number of ill effects, among them stunting the development of rating histories; discouraging high-quality rating analyses and encouraging the shallower kind; incentivizing ratings shopping; and raising the costs for all participants.
"There has been a lot of concern expressed by market organizations, issuers and investors, including the structured finance market, about the impact of mandatory rotation on the market in terms of fostering instability in ratings," said Martin Winn, a spokesman for Standard & Poor's.
For those in the structured finance camp, there would be one more complication: having an agency rotate in and out of a deal while doing the same with the counterparties linked to that deal.
Regulators are hoping that rotation would boost competition in the sector by basically guaranteeing a market share for agencies outside the big three and breaking longstanding relationships between the reigning oligopoly and issuers.
"Rotation can be a good and valuable tool to try to encourage other players to get a chance to play in that playing field and to get to have a go at actually rating issuers they might not otherwise have a chance to rate," said Verena Ross, executive director of the European Securities and Markets Authority (ESMA), in a hearing before the Treasury Committee of the U.K. House of Commons.
Ross has said that the aim is to adopt CRA3 by January 2013. The regulatory body that oversees rating agencies, ESMA declined to answer questions pertaining to rotation, but Ross has made a number of comments on the matter in testimony to the House of Commons as well as other venues.
Ratings Rotation
After adopting new regulations on rating agencies in 2009 and 2010 as a response to the global financial crisis, the European Commission decided that more was needed. For the authorities, the unfolding eurozone drama evidenced continued problems with the way ratings and debt markets interacted.
CA3 was born of this desire, and part of the package is required rotation, which would apply to issuers and transactions in the areas of corporate debt, structured finance and covered bonds.
In a press release from late last year, the EC's Internal Market Commissioner Michel Barnier said that to help eliminate conflict of interest issuers would have to rotate every three years between the agencies that rate them and their transactions. In addition, "complex" structured finance instruments would need two ratings.
But the mechanics of the proposal are more complicated than that. In a recent report, Bank of America Merrill Lynch summarized a few of the main points (see table).
A spokesperson for the EC did not return requests for comment by press time.
In a speech delivered last January, ESMA's Ross did express reservations that there was a risk that new agencies helped along by the introduction of ratings rotation could compete "by offering higher ratings or by lowering prices."
"If new entrants or smaller CRAs are attracted to bid in the rotation process, it is not clear that...their professional competence will be able to live up to the expectations," Ross said. She added, however, that "these risks might only be short-term growing pains."
Players see so many downsides to required ratings rotation that they hardly know where to start.
"Forced rotation is an experiment that will lead to standardization and reduced offering of opinions," said a spokesperson from Moody's Investors Service. "It will remove incentives to improve ratings quality and long-term performance."
Critics argue that as rotation will ensure less experienced agencies some market share, quality will inevitably suffer.
In the House of Commons hearing, Ross acknowledged that ratings quality could deteriorate under a rotating regime. She suggested, however, that new rules on disclosure of asset quality could ameliorate the fragmentary impact of having ratings from different agencies at different times over the life of a structured deal.
"There would be more information about the underlying asset pools made available to the general public and to any rating agencies that would rate," she said, adding that the provision of this data could help mitigate the risk posed by the discontinuity of analysis.
Moody's has also taken issue with other aspects of the CRA3 package. "As currently drafted, CRA3 will not improve ratings quality, but it will damage credit access for European companies and will negatively impact economic growth and job creation," the spokesperson said. "Moody's believes constructive alternatives exist, including reducing regulatory reliance on ratings and encouraging further debate on sovereign credit risk."
The agency declined to comment further.
Measuring Performance
Apart from Moody's, other players raised the question of long-term performance of ratings - how could it be assessed when there is a revolving door of ratings supplied by agencies practicing entirely different methodologies?
In the first round of CRA regulations, a central repository known as CEREP was set up for publishing the rating activity statistics and rating performance statistics of credit rating agencies.
But many players doubt that CEREP or any regulatory body could adequately measure the performances of rating agencies over the life of a transaction if rotation were the law of the land. Indeed, some argue that it would be meaningless to even assemble the individual performance statistics of the agencies covering a given transaction over its life, since each has presumably done so at a different stage in the deal.
"It creates short-term incentives for agencies to rate only to that time horizon," said a market source.
The rotation of analysts - also required by the proposal as it now stands - would further undermine continuity of analysis, sources said. As it is currently drafted, the proposal would not allow someone to be the lead analyst on a deal or issuer for more than four years (see box). What is more, supporting analysts are rotated out after five years.
"It takes time for a rating agency to understand most credit," said a market source. "If an issuer has a new rating agency every year, it could affect their funding flow."
In this sense, however, regulators could be pushing toward exactly what they want: breaking the longstanding relationship with the big three agencies.
A spokesperson from DBRS, an agency outside the inner circle, declined to comment on this issue.
Counterparty Chaos
For structured finance players, the issue of counterparties would multiply the musical chair-like effect that players say rotation will cause. A given agency will be rotating not only in and out of the transaction but also in and out of the counterparties.
There may be periods, then, in which an agency is enlisted to publicly rate a deal while it cannot formally rate one or more of transaction's counterparties.
"How can you justify a downgrade due to counterparty risk?" said Alexander Batchvarov, international structured finance strategist at BofA Merrill Lynch Global Research, adding that somehow agencies would have to find a way to maintain those ratings, unsolicited and, by extension, unpaid.
"It would increase the cost of structured finance ratings," Batchvarov said.
It comes as no surprise that European trade groups representing finance players have come out strongly against this proposal.
Two giants, the European Mortgage Federation (EMF) and European Covered Bond Council (ECBC) have jointly issued a paper attacking mandated rotation as "impracticable," even while expressing support for other aspects of CRA3.
The organizations said that no less than six CRAs would be needed to fulfill the EC's rotation proposal for a typical covered bond program. These programs are usually rated by at least two agencies, and issuers tend to place at least 10 bonds a year. The graph below shows how the ratings geography of a single covered bond program would be in constant flux during its life. The y-axis (A through F) represents the six rating agencies, the x-axis the number of years each would be allowed to rate the program.
The scenario depicted by the graph would also hold true for a long-term securitization.
"[Ratings rotation] implies significant costs on both issuers and investors and is likely to introduce uncertainty and volatility in the ratings process," said the EMF and ECBC.
The trade groups said they agreed with the regulatory ambition of retooling the system so that ratings are not as deeply hardwired into financial legislation as they have been. This hard-wiring, they added, has brought on pro-cyclicality and, in extreme cases, "cliff effects," a likely allusion to the vicious feedback loop that developed between ratings and the sovereign debt crisis in Europe.
EMF and ECBC said that the rotation proposal represents a missed opportunity to actually address the issue of regulatory reliance.
Europe at a Disadvantage?
Sources also argue that rotation would affect the global comparability of ratings from Europe, hurting the appetite of foreign investors for products from the region. With U.K. securitizations finding a warm reception these days from U.S. investors, and European players looking to likewise find foreign appetite for other asset classes, this issue is of acute interest to structured finance players.
"The market is concerned it will handicap European issuers' access to capital markets, in particular relative to non-European issuers," said S&P's Winn.
A market source pointed out that European issuers will have colossal amounts of debt to refinance over the next few years, and they will likely seek out foreign investors to complement local ones. "Those investors are going to look for a range of independent views and global comparability," he said. "They want to be able to compare deals across sectors and jurisdictions." This, he added, will be compromised by the perception that ratings quality in Europe will have eroded thanks to constant rotation.
In general, critics argue that local and foreign investors alike will have to increase their analytic costs, as they may have to understand six different ratings methodologies. Buysiders will also have difficulties plotting out investment schedules on deals with varying ratings, sources said.
Barriers to Entry
The push to have new rating agencies come on the scene may be a laudable goal, but it does not take into account the high start-up costs, sources said. "Regulators themselves estimate that it would cost €200 million to €300 million to set up a new agency," Batchvarov said, suggesting that this would be a drawn-out process.
Ratings Rotation
AS CURRENTLY DRAFTED BY THE EUROPEAN COMMISSION
*An agency should not issue ratings for a period of more than three years on an issuer that pays the agency for that rating.
*however, when an issuer requests ratings from more than one rating agency, then only one CRA has to rotate but the maximum contractual relationship with any CRA should not exceed six years.
*A CRA can rate the same issuer again after a cooling-off period of four years has elapsed.
*A shorter period might apply if the CRA has rated 10 consecutive debt instruments of the same issuer, but the CRA can keep rating the issuer for up to a one-year period if the 10 consecutive ratings were completed in under a year.
*lead analysts cannot be involved in the rating of an entity for more than four years.
Source: Bank of America Merrill Lynch
