European market regulators to find out about the competence of credit rating agencies in grading the risk of securitized debt behind the recent credit crisis that paralyzed financial markets.
The European Commission wants to look at why rating agencies such as Standard & Poor's Corp., Moody's Investors Service Inc. and Fitch Ratings were slow to downgrade investments based on U.S. housing loans to borrowers with poor credit months after a sharp rise in people defaulting on their mortgage payments.
Many of these debts were repackaged as asset-based securities and sold to banks that did not know or understand the potential losses they were taking on - triggering a lack of confidence in August that saw lenders suddenly baulk at taking on new debt.
The Committee of European Securities Regulators - which advises the EU executive and finance ministers - said they have been instructed to look closely at rating agencies, examining possible conflicts of interest and the agencies' ability to rate debt.
In a letter to the regulatory committee dated Tuesday, EU Financial Services Commissioner Charlie McCreevy said doubts had been raised about whether rating agencies had adequate resources to understand the "rapidly changing and growing complex structured finance market."
He cited the high turnover of analysts, asking regulators to plot the growth in the number and experience of those who rate securitized assets against the rapid expansion of the industry.
Regulators should look specifically at the "apparently slow response" of rating agencies to problems with subprime mortgages after ample evidence of mounting defaults from the second half of 2006. McCreevy asked the committee to assess whether regular quarterly or half-yearly reviews of all individual structured finance ratings "might be necessary, even mandatory."
He was also looking for a better picture of how rating process and methodologies can be improved and for the regulators' opinions on whether rating agencies provided investors with adequate warnings about the assumptions behind their advice that would point out the short history of data for securities.
Their probe should also look at how rating agencies reward employees to check if the promise of performance-linked bonuses are "sufficiently deferred to ensure that ... there is indeed sufficient incentive for the long-term value of the rating franchise to be at the forefront of the their priorities when managing the business."
McCreevy earlier flagged up possible conflicts of interest in the sector because rating agencies grade the debt sold by the banks that they depend on for their livelihoods. His letter says this problem could be more pronounced for securitization and structured credit, asking the regulatory committee to focus on this because this may be a far more lucrative market for agencies.
McCreevy said he would like a response as soon as possible and no later than April 2008 when regulators will present a regular report on the agencies. The commissioner has the power to put forward new EU-wide rules for the financial market.