The Role of Credit Ratings in the Future of Capital Markets:
a conversation with Deven Sharma, President, Standard & Poor’s
Thursday November 13th, 2008
Moderator Garrick Utley, President of The Levin Institute, began by mentioning that President Bush made some remarks that day about the state of the capital markets, and cautioned about over-regulation, killing the goose that, until recently, laid a lot of golden eggs. He then asked Mr. Sharma about the state of the capital markets today. Mr. Sharma replied they remain a bit frozen, but are loosening, though the process may yet take months. Specifically, LIBOR rates continue to decline, capital is coming in, and we have “stepped away from the abyss.” But again, full restoration may take awhile.
Mr. Utley then asked about Secretary of the Treasury Paulson’s plan to use the government’s bailout plan to recapitalize banks, instead of purchasing financial assets like mortgages from the banks. Mr. Sharma answered that it was necessary to recapitalize financial institutions in the first instance, functioning capital markets are a sine qua non, but now attention must turn to consumers, and in particular the need to stabilize housing prices.
Then Mr. Utley asked about how we got to where we are, noting that former Federal Reserve Chairman Alan Greenspan recently issued a mea culpa for his activities when he was in office. To what extent were the rating agencies also responsible? Mr. Sharma replied that the agencies made two mistakes: They greatly underestimated the amount by which housing prices would fall—the actual decline was two times what S&P had assumed—and they did not foresee that the housing recession would be national in scope and not just in certain regions—
S&P had assumed a low correlation among regions. But he also pointed out that investors had misused ratings, taking them as investment advice instead of just a reflection of creditworthiness, that is, the likelihood of default. He also mentioned that prior to 2004, ratings did not misperform significantly, but that changed thereafter. He also noted the anomaly that homeowners were now more willing to default on their mortgages before defaulting on their credit cards, the reverse of the historic trend. Mr. Utley noted the number of AAA ratings that failed; Mr. Sharma replied that S&P rated $3.5 trillion of structured securities in the 2005-2007 time period, and only 20% of those ratings had to be changed, and less than 2 % defaulted.
Talk then turned to the future. Regarding the likelihood of more regulation, Mr. Sharma noted that the European Union has discussed requiring the rating agencies to register and be subject to regulation, but noted that it is important to maintain the agencies’ analytical independence and the international consistency of ratings; regulations can be interpreted differently by EU member states, but markets are global.
Mr. Utley noted that much has been made about the rating agencies’ possible conflicts of interest. There are three possible ways the agencies can be paid: The issuer of the securities pays for the rating (the current model); the investors do, by subscribing to the agencies’ opinions (the method prior to 1970); or the agencies are “nationalized” and treated as a public utility. Mr. Sharma said the second method, where investors pay, hurts transparency because only subscribers receive the ratings, and it is better that the ratings are made public for all to see. Nationalization—public ownership of the agencies by the government—is also bad because the ratings, like the markets, must be global, not national. Mr. Sharma said S&P has put in more checks and balances, including an ombudsman, and that a recent SEC study found no significant conflicts of interest in the present system. 
Mr. Utley then asked if the markets had gotten so big and so complicated as to be impossible to manage and analyze. In reply Mr. Sharma said that securitization was a good thing, and led to an increase in capital overall of $2 to $3 trillion.
In response to questions from the audience, Mr. Sharma said that S&P’s methodology was not just-model-based, but also included fundamental analysis; that while in the past S&P relied on the securities issuer to certify by representations and warranties that (e.g.) the loans in a pool met certain criteria, now S&P has a third party perform the due diligence on the assets; that the SEC has recently approved ten new rating agencies (called Nationally Recognized Statistical Rating Organizations, NRSROs); and that S&P does more than just ratings—its various securities’ indices like the S&P 500 have become the benchmarks for performance throughout the securities industry.
The conversation concluded with the likelihood and desirability of a global framework and global consistency in the securities business. Mr. Sharma pointed out that again, there are so many countries involved it would be difficult to achieve. Perhaps the International Monetary Fund or the Financial Stability Forum could take a role here. Mr. Sharma also pointed to the example of the central banks’ recent extraordinary cooperation in addressing the global credit crisis—could such cooperation and coordination be more formalized?-- and how the upcoming meeting in Washington of world leaders on that topic will be of the G20, not just the G7 or G8, as countries like China, India, and Brazil assume more financial power.