Moody's and Merrill revise rating systems - Emirates24|7

Moody's and Merrill revise rating systems

Two major research firms yesterday announced changes in the way they rate companies and financial instruments to provide greater transparency and differentiation and to allow investors to better manage risk.

New York-based Moody's Investors Service said it will introduce two supplemental measures to its structured finance ratings to enhance their transparency and information content. The Assumption Volatility Score will assess potential rating volatility based on the uncertainty of rating model assumptions. Loss Sensitivity will capture a rating's sensitivity to a change in the expected loss rate on the collateral pool backing the security.

"These two measures will provide more clarity about the credit characteristics of structured finance ratings," said Michel Madelain, the new Chief Operating Officer at Moody's.

"We believe they will provide investors greater insights into the risks of structured finance products."

Merrill Lynch Global Research, also based out of New York, announced a new system of equity ratings designed to provide clients with enhanced transparency into analysts' views, differentiation among the equity ratings within a sector, as well as closer alignment between rating distributions and historical stock performance.

"The basis of the new equity rating system is to reinforce our ongoing drive to encourage Merrill Lynch analysts to adopt the perspective and mindset of top-performing investors," said Candace Browning, president of ML Global Research.

In Merrill's new system, "Buy" stocks are expected to have a total return of at least 10 per cent and are the most attractive stocks in a coverage cluster. "Neutral" stock prices are expected to remain flat or increase, but be less attractive than Buy-rated stocks. "Underperform" stocks are expected to have either a negative total return or have a positive total return but be the least attractive stocks in a coverage cluster. These structural changes come in the wake of the sub-prime mortgage crisis and the criticism that rating agencies in particular have faced over the way they have dealt with complex financial instruments.

Moody's, Standard & Poor's and Fitch Ratings have been forced to downgrade billions of dollars of securitised products in the past eight months. Moody's this month replaced COO Brian Clarkson with Madelain.

Last month, the Financial Stability Forum, a committee of central bankers and regulators, urged the rating agencies to change their system of measuring risk for corporate bonds and securitised products.

Moody's developed its new measures working from responses to a call for comment issued in February, "Should Moody's consider differentiating structured finance and corporate ratings?", and from additional market discussions. Moody's received more than 200 responses, including from investors that together held in excess of $9trn (Dh33trn) in fixed income securities.

In their responses, market participants overwhelmingly rejected the idea of a separate rating scale for structured finance securities. However, they also voiced a desire for more information from Moody's on key components of structured finance risk. These included the degree of certainty in the assumptions behind a structured finance rating and the sensitivity of a rating to losses in the loan pools.

The Assumption Volatility Score, or V score, will rank transactions on a one-to-five scale by the potential for significant changes owing to uncertainty around the assumptions and the modelling that underlie the ratings. A single V score will apply across tranches to an entire transaction.

The V score will be the composite score on factors including historical performance, data adequacy, the complexity and market value sensitivity of a transaction, and governance.

Loss Sensitivities will measure the number of rating notches Moody's would expect a security to be downgraded should the expected loss rate on its underlying collateral pool increase to a highly stressed level.

Specifically, the measure looks at the change in ratings that would follow the expected loss rate on the transaction's underlying collateral pool increasing to, for example, a 95 per cent loss level stress, that is to a level expected to have a one-in-twenty chance of occurring.

Merrill's new system also introduces dispersion guidelines that limit the number of the stocks in each rating category: Buy-rated stocks may not exceed 70 per cent, Neutral-rated stocks may not exceed 30 per cent and Underperform stocks must be at least 20 per cent of each coverage cluster.