The obscure workings of the credit rating agency
Alex Preston’s early days in the City were spent as a credit analyst in a Mayfair hedge fund –– on t
Quis custodiet ipsos custodes? Um . . . well, I did for a while. If the particular custodes we're talking about are the credit rating agencies. My first job out of university was as a credit analyst at a hedge fund in Mayfair. I'd be given research reports written by the three rating agencies - Moody's, Standard & Poor's and Fitch Ratings. And every discussion with the portfolio managers came down to the same question: did I agree with the agencies' rating of a particular company? And if not, why not?
Credit rating agencies opine on the creditworthiness of companies, countries and the complex asset-backed securities whose unravelling kick-started the credit crunch. They score each particular entity using a spectacularly arcane "model" that spits out a rating like an exam grade - anywhere from D (for dunce) to AAA (massive swot). The UK and US governments are rated AAA. So were the vast majority of sub-prime securitisations created during the boom years. Ratings aren't optional - if you want to issue a bond or loan, you need to get a rating. And if the agencies don't like what they see, they hit you with a low (or "junk") rating, meaning that you have to pay an awful lot more to raise money from investors.
The hedge fund I worked for insisted on having credit analysts verify the ratings issued by the agencies. Many funds relied solely on the work done by the agency research teams. Indeed, the rating agencies have knitted themselves so successfully into our financial system that the level of capital that banks have to hold against investments on their balance sheet is ruled by the agencies' ratings.
Twenty years before the crash of 1929, and exactly 300 years after the Dutch Tulip Company created the financial markets by issuing common stock, John Moody set up the first credit rating agency. Moody's gave ratings to the various American railroad companies whose stock dominated the markets at the turn of the 20th century. Poor's, which started off as a financial journal, moved into the rating business in 1916 and merged with the Standard Agency in 1941, while Fitch - the smallest of the agencies - was formed in 1913.
The agencies began as a subscription service paid for by investors; as they became official arbiters of credit quality in the financial markets, however, their business model changed. The agencies began to collect their fees from the companies they were rating. The conflicts that could (should?) have brought the agencies down in 2008 lie in this bizarre system. It's like suggesting that the contestants on Britain's Got Talent pay the wages of Simon Cowell, Amanda Holden and Piers Morgan; but with the proviso that the amount paid by each contestant be kept secret, and that they have the right to receive their feedback in private if they don't want to be humiliated in public.
The rating agencies are finally coming under serious scrutiny from the regulators, however. Even Warren Buffett - who owns 13 per cent of Moody's -admits that the agencies' model is flawed. The financial regulation making its way laboriously through the US legislative system looks as if it will result in major changes to the raters' mandate. As with the sub-prime nonsense and the bonus culture, everyone in the City knew that there were huge conflicts at the heart of the rating agency system; but while the gravy train was rolling, no one wanted to risk shouting about it.
When I went to work for the credit trading arm of a Dutch bank in February 2007, I was delighted to see the floor full of familiar faces. The City once looked down on rating agency analysts, but with the advent of structured products this was no longer the case. The "Credit Exotics" desk at the bank was staffed almost entirely by ex-agency analysts, many of whom I knew. They were brought on board because of their inside knowledge of the obscure rating models. Maths geeks to a man, they were able to show the investment bankers how to "optimise" the ratings system in order most efficiently to package up sub-prime mortgages, among other assets.
The rating agencies were seen by my peers as a stepping stone in their careers, a place to learn about credit before moving into a more challenging (and better-paid) role at a bank or hedge fund. Agencies paid much lower salaries and minimal bonuses and the work was often drearily repetitive. The agencies themselves made a fortune during the boom years; they just didn't pay out much of that fortune to their junior staff. So as soon as these guys learned the ropes, they jumped ship to the nearest bank. There they helped create the products that led to the market meltdown of autumn 2008.
The rating agencies continue to wield enormous power: a mini-recovery in stocks at the end of May was brought to an end when Fitch downgraded Spain's credit rating; David Cameron has been warned by both Standard & Poor's and Fitch that he needs to move more swiftly to address the Budget deficit if he wants the UK to maintain its AAA rating; and the agencies are once again rating mortgage-backed securities. The markets continue to rely on ratings as the only "independent" marker of a company's or a country's financial stability.
And my own track record in rating the rating agencies? The first company I was given to look at was a gas utility called Enron - at that time rated BBB+, or investment-grade. I noted a variety of income streams and the excellent reputation of the firm's management. I suggested that the agencies should move to upgrade Enron in the near future and proposed that we invest in its medium-term notes. Thankfully, the portfolio managers ignored me.
Alex Preston worked for a decade in the City. His first novel, "This Bleeding City", is published by Faber & Faber (£12.99)