U.S. rating agencies are coming under scrutiny in the public eye, as the severity of negative subprime mortgage performance - and its ultimate impact on structured finance CDOs - has renewed the attention paid to credit ratings. Some on Wall Street are privately chuckling at the triple-A ratings assigned to certain deals in recent months, and expect that it's only a matter of time before regulators turn more attention to the agencies.
The pressing issue: In a market where trading is thin and even primary pricing levels are increasingly difficult to ascertain, is there too much reliance on ratings alone for investment decisions?
And - at a time when structured products are very complex, leveraged and tied to market risk - are rating agencies (or regulators) doing enough to protect investors?
Last month's International Monetary Fund Global Financial Stability Report specifically warned that one of the most currently significant global risks is the way that "the rating agencies continue to expand the application of their ratings beyond the traditional credit risk domain."
Washington think tank the Hudson Institute cited the above statement in a recently released draft paper concerning the effectiveness of RMBS, and subsequently, CDO ratings.
The institute's scholars argued that investors, particularly in triple-A notes, often lack the sophistication and information to adequately test expected returns themselves, thus forming an unhealthy reliance on rating agencies - akin to a dieter's dependence on a "fat free" label to determine nutritional content. The reliance, according to the institute, creates misvalued and "marked-to-model" investment portfolios.
The situation becomes particularly troubling amid a rapid selloff of securities due to a rash of rating agency downgrades, according to the paper. The ratings-based buy and sell decisions play a significant role in the formation and collapse of credit bubbles. This collapse ultimately creates - in the context of the current environment - an unstable U.S. housing market and, subsequently, the economy, the institute argued.
For their part, rating agencies point out that they do disclose the risk associated with ratings supplied to certain bonds, and are careful to specify which portion of a bond's risk is being rated, exactly. Further, while the largest portion of CDO notes issued in the U.S. market are triple-A rated - those notes are the least likely to endure a sudden rash of downgrades.
But while sophisticated investors generally "re-rate" the securities they choose to buy using internal analytics, not all investors have those tools available, and synthetic technology has created some of the most highly levered triple-A rated notes yet.
Some on Wall Street are wondering whether rating agencies are hungry to rate some of the newest structures to hit the market - such as CPDOs - for fear of losing revenue amid declining RMBS and (projected) SF CDO issuance.
But maybe they're not hungry at all. Dominion Bond Rating Service and Fitch Ratings late last month simultaneously released reports criticizing the CPDO structure. Fitch went as far as to say it would not have assigned triple-A or even double-A ratings to the so-called "first generation" of the structures.
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