Agency Problems

Most of the 64,000 triple-A ratings awarded to structured finance securities by the major rating agencies during the credit bubble went into the dustbin of history. So did a large part of the reputation of the credit rating agencies themselves, according to many observers, me included.

But the agencies are still there and, if current regulatory trends are any indication, we’re building more ratings-dependent triggers into the system, rather than fewer. It seems a case of “better the devil you know” where the credit rating system is concerned.

Take yesterday’s downgrade of Greek sovereign debt by Fitch to BBB+. One of the first comments made by the head of the Greek central bank in response to the downgrade (reported by Reuters, picked up by the perceptive FT Alphaville team yesterday) was that there is still “a safe distance regarding collateral problems with Greek sovereign bonds.”

What’s Mr Provopoulos referring to? Under the emergency collateral rules brought in by the European Central Bank in October last year, government bonds eligible for obtaining ECB financing must be rated BBB- or more, with anything below BBB subject to a haircut. Taking Fitch’s new rating of BBB+ as a starting point, Greece can fall by two more ratings notches before the ECB says no to more credit.

In fact, making no pretence of conservatism, the ECB rules state that “if multiple and possibly conflicting ECAI (external credit assessment institution) assessments are available for the same issuer/debtor or guarantor, the first-best rule (i.e. the best available ECAI credit assessment) is applied.”

So Fitch, for example, can downgrade Greece all it likes, but as long as Moody’s sticks at A1 (where it currently rates Greece) there’s no problem, as far as the ECB is concerned.

Talking of Moody’s, the agency is now indulging in semantics worthy of a medieval theologian to avoid downgrading certain countries from the top AAA grade. According to Bloomberg, you can now be a “resilient” or “resistant” AAA category borrower (resistant is better, by the way). And while the UK’s credit default swap spread is now 83 basis points, riskier than Portugal (which is rated Aa2, two notches below AAA), Britain still clings on to the top grade from Moody’s perspective.

The most that the rating agency will currently concede is that “the UK and the US have ‘lost altitude’ in their ratings even as they remain resilient.”

What’s the relevance of all this to ETFs? Well, the CESR (Committee of European Securities Regulators) has made it clear that it is likely to bring in new collateral guidelines for UCITS funds early in the new year.

If these were to look anything like rules recently introduced by the UK regulator, the FSA, for banks, then there could be an emphasis on holding significant quantities of “high-quality” government bonds.

Increasing demand for government debt in this way at a time when there’s a tidal wave of supply seems a no-brainer for politicians and regulators, but it may not be such a good deal for investors. If such a change were to take place for UCITS then there would be an impact on the economics of swap-based ETFs (these currently hold a variety of assets, including equities, as collateral), which could be reflected in an increase in fees.

More broadly, though, creating more ratings-based eligibility rules for collateral – quite apart from the unreliability of the ratings themselves – would surely contribute to instability in the financial system. It was, after all, a likely downgrade of AIG below the AA mark that pushed the company over the edge (it was written into many of the insurance company’s derivative contracts that it would have to post substantial extra collateral in the case of such an event, something it could not afford).

Just imagine the market fallout from a sovereign downgrade if tens of billions of bonds that had been held as collateral purely on the basis of a rating assessment suddenly became ineligible and had to be dumped in the market. A government could go from being in a stable funding situation to near-default almost instantaneously, with catastrophic consequences.

At the Global Securities Lending seminar that I attended ten days ago, moderator Roy Zimmerhansl forecast that 2010 would be “the year of collateral”. I’m sure that many people in the finance industry, including European ETF providers, will be watching regulatory changes on this front very carefully indeed.

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