Squeaky wheel gets the grease: the case of the credit rating industry offers a lesson to risk managers worldwide.(International feature)

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The causes of the global financial meltdown have been pored over and discussed ever more vividly and frequently since banks started folding and bailout measures were passed in the last half of 2008. While it was easy at first to find a quick scapegoat, namely, the admittedly troubling concept of corporate greed and the role it played in the downfall, analysts, regulators and laymen alike, in break rooms, boardrooms, family rooms and committee chambers, came to the lamentable conclusion that the credit crisis had not happened so simply. Multiple well-intentioned policies and programs weighed negatively on the economy, as did widespread financial illiteracy, greed and sins of both commission and omission; it's certainly easy to blame the executives who committed dirty deeds and relied on a short-sighted cash-grab philosophy, but it's important to remember that many businesses and risk managers gave up on the idea of due diligence throughout the downfall, and were willing to accept certain securities and financing setups that, with a little more investigation, would've been promptly rejected by any reasonable financial manager.

"There's plenty of blame to go around," said Ben Boylan, a vice president at Coface and head of the company's rating service in North America. Boylan noted that while much of the responsibility for the subprime mortgage explosion lies on the companies who structured these securities and the companies that rated them higher than they should've, it's also important to remember that across the globe, risk managers relied too heavily on one rating, or embraced the same shortsighted methods as issuers and rating agencies. "It's easy to point the finger at the ratings, but they have their counterparts." The ratings to which Boylan is referring specifically are those issued by big agencies like Standard & Poor's, Moody's and Fitch, companies that have recently discovered that, while great uncertainty still characterizes the political and economic landscape, the one certainty that can be drawn from any crisis, such as the one that's currently shackling the global economy, is that regulation and government intervention are inevitabilities. Legislators and regulators the world over have sprung to action, charged with both improving the current state of global credit availability as well as making sure this crisis never repeats itself, and one of the first sectors ripe for regulation is the credit rating industry.

Conflicts of Interest

The biggest, most notable charge leveled at credit rating agencies is that their pricing structure leaves a lot of room for potential problems and impropriety. When a company or institution is seeking a rating, they approach one of the agencies and pay for their rating themselves at a negotiable price. Conventional wisdom would lead one to believe that maybe having big companies pay to have their own securities rated isn't the best way to keep the ratings impartial, but such wisdom has eluded the industry and regulators for as long as the industry has been around. "I think the main bone of contention is in the way potential conflicts of interests are handled," said Boylan. "It's always seemed a little odd to have the credit rating agencies being paid by those they're rating, but it's a long-established system."

Aside from this somewhat glaring quandary, which new proposals by the United States and the European Union address in their own ways, other issues led to the global reexamination of the credit rating industry, including a disparity between the expertise of those who were structuring mortgages and securities and those who were rating them. "I guess in my view, the ratings models were not adequate or suited to rating the type of very complex securities that were being created by packaging subprime mortgages. The failure to recognize this seems to have been a major factor," said Boylan, who added that Coface was in the process of launching its own rating service that aims to avoid the securities that caused all the trouble.

"We have a philosophical problem with rating exotic securities in the sense that they often become no one's baby," he said. "It's often very hard to know who owns what." Heavy reliance on ratings as a way to judge the creditworthiness of an entity and its issued financial obligations, coupled with rating models that couldn't accurately or correctly judge such an item, led many to make poor investments, which in turn led to the collapse that's currently gripping the global credit markets.