naked capitalism

Standard & Poor’s is to announce some measures today in an effort to bolster its damaged reputation. These moves seem a bit late in coming, given the firestorm of well-deserved criticism aimed at rating agencies. Indeed, the timing is a bit sus, as they would say in Australia, coming only as international regulators are considering how to improve rating agency conduct. The decision to issue the press release now could be viewed as an effort to take the wind out the sails of the International Organization of Securities Commissions plans to implement a code of conduct.

Unfortunately, S&P’s changes focus mainly on the possibility of individuals being co-opted by their clients, either by working with them for too long or seeking to curry favor in the hopes of getting a job with them. And even those measures look ineffective. Five years seems too long a period to have an analyst stay with the same company if the concern is loss of objectivity (although it admittedly takes time to get to know a company well).

There are also plans to improve statistical measures, but as we saw with subprime asset backed securities, many important metrics were added late in the game and earlier issues were not re-rated using the new screens. It isn’t clear whether practices like that will remain in place. And even if you run all the right ratios, if you have unrepresentative data, like 2006 & 2007 mortgages that are vastly worse than earlier vintages, all better computations give you is even greater false confidence in a “garbage in, garbage out” exercise.

The real problem that the agencies are paid by the very organizations they rate, and as long as this conflict remains, all other measures are mere window-dressing. The creation of an ombudsman role is an inadequate, unrealistic remedy for a problematic payment structure.

Yet the ratings agency appears to believe this approach will work. In the Wall Street Journal, Deven Sharma, S&P’s president said, “By increasing transparency, we can increase the confidence in the credit market.”

If S&P really believes a few organizational tweaks will save their reputation and along with it, the debt markets, their judgment is badly impaired. This statement is simultaneously woefully misguided and grandiose.

From the Wall Street Journal:

Standard & Poor’s Ratings Services plans to announce 27 separate actions it will take in hopes of bolstering confidence in credit markets and the bond-rating firm’s analytical integrity, including tougher oversight of analysts to spot potential conflicts of interest.

Some of the changes by the McGraw-Hill Cos. unit are organizational and cultural moves aimed at countering criticism that rating firms have grown too close to underwriters and other entities….

Among the changes set to be announced today, S&P will rotate lead rating analysts after five years of following the same company, government bond issuer, or structured-finance arranger. The new practice, which will be phased in, should prevent professional or personal relationships from affecting ratings, company officials said.

Analysts who leave S&P to work at a bond issuer will have some deals they previously rated reviewed to make sure their objectivity wasn’t compromised by the prospect of the new job.

Meanwhile, ratings analysts will be required to undergo more training, surveillance tools will be added to track structured-finance performance and S&P will establish an ombudsman to address concerns about potential conflicts of interest in the rating process. An auditing or governance expert also will be brought in to publicly review S&P’s processes.

Some additional tidbits from Bloomberg:

Standard & Poor’s plans to hire an ombudsman, demand disclosure of collateral that backs structured finance securities and change the way it measures risk in response to losses in mortgage-backed securities….

The changes come a day after the International Organization of Securities Commissions in Madrid said S&P and rival Moody’s Investors Service may face a code of conduct prohibiting “advice on the design of structured products which an agency also rates.” IOSCO, the forum of securities regulators, also urged financial institutions to disclose their risk of losses from structured finance….

Potential conflicts of interest between rating companies and the banks that pay their fees were flagged last year by European Central Bank President Jean-Claude Trichet and U.S. Senate Banking Committee Chairman Christopher Dodd. The Securities and Exchange Commission said in August that it was examining the way the companies assign ratings…

S&P also plans to hire an outside firm to periodically review procedures, create an independent risk assessment oversight committee, build an analyst certification program and add more information to ratings including liquidity and correlation assessments.