Q.&A. With S.&P.’s President on the State of Ratings
Jun 4, 2010
The credit rating agencies have been under continuing assault for the triple-A ratings they gave to billions of dollars of mortgage-backed securities that turned out to be virtually worthless when the housing market collapsed, propelling the financial crisis.
The agencies faced renewed scrutiny this week at a government hearing, where executives of Moody’s Investors Service tried to explain the rationale for their ratings and the billionaire investor Warren E. Buffett, a big shareholder of Moody’s, offered a tepid defense. Meanwhile, several lawmakers are pushing amendments to the financial regulatory bill that would fundamentally change the way the rating agencies do business.
Deven Sharma, above, the president of Standard & Poor’s, sat down with DealBook to discuss the past, present and future of the rating agencies.
He acknowledged that analytical mistakes were made as the housing boom expanded, but said his company had since made a concerted effort to change its methodology.
Mr. Sharma is supportive of certain issues in the financial regulatory bill, which might seem surprising given that the bill could threaten his company’s dominance in the credit rating business. He also spoke about what could be the next major crisis and how S.&P. is watching it closely.
The following are edited and condensed excerpts from the interview:
Do you believe that there was an overreliance on credit ratings during the boom? Did we expect ratings to do too much?
I think ratings were used in ways that they were not intended for. Ratings only address the credit risk. There are some segments of investors that perhaps used a rating as a recommendation for investments, but it is not designed for that. It doesn’t address the valuation or volatility; it just addresses credit risk.
Building on that, do you support the LeMieux-Cantwell amendment in the Senate version of the financial regulation bill that aims to tackle this overreliance problem by no longer requiring issuers to get a credit rating for certain securities?
Yes, we do. We say, “Take the mandate away and let us compete.” The moment you mandate it, it become an endorsement from the government, which leads to overreliance.
If taking the mandate out proves to be too difficult from the policy-making view, then include other benchmarks in it so that people look at the market risk, valuation and volatility, not just credit risk that our ratings provide.
Do you believe S.&P. would continue to dominate the ratings space if you lost that government stamp? If people aren’t required to get a rating, will they go out and get one?
I believe that investors want and need a benchmark. If you take the mandate out, I believe we will just have to work harder, as we do in our other businesses, to convince people that our ratings are better than others.
Do I believe that there is a need for a credit risk benchmark for investors? Yes. But let us go prove the value of that to the investors and demonstrate to them that what we do will be helpful for them and then we will convince and persuade them to use it — but don’t mandate us.
The empirical evidence of this is that when we started to build our businesses outside the U.S., there was no mandate in other countries to use us. But we built the business and became very successful anyway. Now some foreign governments want to start mandating ratings, and we say, “Please don’t.”
Do you think the issuer-pay model can survive? Is there a better way?
There are multiple types of pay models you can look at, but there is not a model we can see that is without conflict — whether it is subscriber pay or a government-owned entity. While in an issuer-pay model there is a potential for conflict, it also brings full transparency to the markets. Whereas the investor-pay model is also not without conflict, but does not allow any transparency in the marketplace.
So since no model is without conflict, our point of view is to impose the oversight on us, impose the accountability on us, impose the transparency on us and let multiple models coexist and compete. And if investors feel that we are not generating integrity, they will move away from us.
What do you think of the other major proposal in the financial regulation bill overhauling the credit ratings agencies: the Franken amendment? It would create a government-led council to assign financial products to ratings agencies instead of the issuers shopping their products around.
Our preference would be to take the mandate out — allowing more transparency and oversight on us through the S.E.C. We are concerned that if the selection of a rating agency doesn’t work out for some reason, who is accountable for it? The rating agency or this board? Also, how do you make sure there is not conflict of interest on this board?
The Franken amendment is taking aim at the apparent conflict of interest in which rating agencies are played off one another by the issuers, who ultimately pay for the ratings.
That is shifting the conflict. Isn’t there a better way to solve that: to have more transparency. The government could force issuers to tell the marketplace which rating agencies they went to and who they selected and why they selected. We would say who came to us for issuance and make it public.
So would you be willing to disclose how much money S.&P. made in issuing ratings to certain clients?
I don’t think you want to do transaction by transaction, but instead to say, “Here’s the total revenue we got on this issuer.”
Warren Buffett warned that the next big crisis would come from municipal and state bonds. What do you think?
We have made several downgrades to highlight the rising risks in that area. What people don’t understand is that there are nuances in municipals that make certain issuances in that asset class very different. For example, there are certain states that put the payment of debt at a higher priority than other services, so as a result the ratings will reflect that.
But one of the major complaints of the ratings agencies is that you practice a kind of “ratings inflation” in some politically delicate bonds — for instance, the general obligation bonds in California or the sovereign debts of powerful nations.
We downgraded California 18 months ago, even though Bill Lockyer [the California state treasurer] lashed out against us. Ratings are opinions on relative risk. All we are saying that if you look at Rhode Island and look at California, which one is closer to the prospect of default — that is all it means.
I think in California they have clauses in which their general obligation bonds have to be paid first before anything else. In the end, it is the services that will be cut, the debt will be paid. But public entities, like if you are a sewer system or a hospital, those are different issues.
What do you think of the regulatory proposals out of Europe that would create a unified council with substantial powers, that would force credit rating agencies to reveal the models they use when they upgrade or downgrade sovereign debt?
I am not familiar with the proposal, but European regulation now calls for regulators to look at how we develop our processes, how we develop our methodologies and all that. So if it is around that, we are fine with that. But if it is to come and tell us what are methodologies should be, that would be encroaching on analytical independence. We would rather not rate debt than submit to compromising our analytical independence because out first obligation is to investors.
Do you think the rating agencies were too slow to downgrade the European countries like they were with mortgage-backed securities in the United States, and do you think there will be more downgrades to come?
We don’t speculate about future ratings, but if you look at the sovereign ratings, and I know there has been some debate about that, it has been sometime over the last three for years that we have been changing the ratings across different countries. So we are responding to issues as we are seeing them.
But then we got heat from one set of actors that said we are overreacting, and another group of players who said, “Slow again.”
Have you made any changes to your methodology since the subprime mortgage crisis?
There have been lots of changes. For example, it is going to be much more difficult for a mortgage-backed security to get a triple-A going forward. Look, we have made a number of changes in the organization around analytics, around a number of other governance to add more checks and balances.
Not everything went right in the past, and we recognize that. And there were analytical misses, and we know we have to learn from that and fix things. But at the same time, we are going to stay true to our purpose, which is offering a risk benchmark and calling it as we see it and taking the heat as it comes along.
– Cyrus Sanati