Help needed to reduce reliance on credit ratings

NEW YORK (Reuters) - Weaning financial markets off their reliance on credit ratings is likely to require greater government intervention, as firms or investors who seek new ways of measuring risks may be downgraded themselves.

New rating models, meanwhile, should be based on statistical fundamentals and limit human interpretation to ensure a more objective view of risk, said former rating agency officials.

The Obama administration has said it wants markets to reduce their reliance on ratings after Moody's Investors Service, Standard & Poor's and Fitch Ratings created a false confidence in risky assets that in many cases defaulted.

Subsequent losses sparked global flight out of credit securities, leading to a slump in economic output around the world.

However, "its not possible to rely 'less' on rating agencies, you either rely on them 100 percent or you do not," said Sylvain Raynes, founding principal at R&R Consulting in New York, and former Moody's analyst.

"It cannot be done piecemeal, this is why the government needs to take charge," he said.

Credit ratings are embedded in contracts across financial markets and are used to govern trillions of dollars of investments made by fund managers, the amount of collateral required to back derivatives, and the cost companies and municipal issuers pay on their debt.

The prevalence of clauses in investment contracts based on ratings levels has the potential to cause large-scale disruptions by sparking a sell-off in bonds or other rated assets.

Concerns about tens of billions of dollars in collateral that American International Group (AIG.N) would need to post due to a ratings downgrade led to the insurer being bailed out by the U.S. government.

Removing ratings triggers is complicated as the institutions that use them are rated themselves, and these ratings could come under pressure if their exposures are not also ranked by the agencies, said Raynes.

For example, some commercial paper conduits have quietly eliminated NRSRO (nationally recognized statistical ratings organization) rating requirements from their portfolios, but cannot publicly make this clear for fear the conduits' ratings will be cut by the agencies claiming that they cannot measure the risk of assets in their portfolios, he said.

Investors who buy securities often demand ratings from NRSROs. S&P, Moody's and Fitch are the largest of the elevenNRSROs.

Critics of the industry argue that decisions by ratings analysts can be swayed by the fact that their agencies are paid by companies issuing debt, and by concerns over the potential implications of a downgrade.

Investors are continuing to put ratings triggers into new contracts because they can't see an alternative, said Jerome Fons, principal at Fons Risk Solutions, and former managing director of credit policy at Moody's.

"What we need to do is get away from large institutions having all the power. The danger with the current reforms and proposals are that we franchise and further entrench the large firms," he said.

NEGATIVE SPIRALS

New ratings models should be more objective, by having a stronger emphasis on fundamental data and minimizing the influence of human judgment, said Fons and Raynes.

Ratings triggers also need to be removed from contracts in any instance where a rating downgrade could precipitate a negative spiral, as happened with AIG.

"A rating system that everybody relies on and piles on top of is doomed to fail, because it becomes self fulfilling and it actually becomes driving behavior," said Fons.

"The question is can we come up with systems that are based on metrics or models or something that isn't going to be self-fulfilling," he said.

Performance data for loans backing structured products, including collateralized debt obligations (CDOs) should be made publicly available, said R&R's Raynes.

At that point, investors and credit analysts can come up with their own value for a deal, he said.

CDOs backed by mortgages were central to the expansion of bad mortgage credit.

"With data, unlike relying on a person, everybody can check for themselves. These are widely and generally available, so if you have a model based on that anybody can check your answers," Raynes said.

"Those data are the ground of the agreement that removes the necessity for a rating analyst to exist," he said. The government should play a role in making the data available.

Markets should move toward having more credit analysis being made at the level of the investor.

"I'm hoping there will be what I call a democratization of credit where individuals are empowered to do analysis. It isn't rocket science, it isn't super hard to do," said Fons.

(Reporting by Karen Brettell;)