Thursday, 6 September 2007

McCreevy downplays talk of hedge fund regulation

EU internal market commissioner Charlie McCreevy has never been noted for his enthusiasm for intervention in the capital markets. True to form he is quick to absolve them of blame for the recent financial turmoil (is it a crisis, yet?). I blogged earlier this week about some political appetite to look at hedge fund operations, McCreevy clearly isn't onside.

From today's Times:

Charlie McCreevy, the European Internal Market Commissioner, said yesterday that hedge funds had been particularly active in troubled structured credit markets, but absolved them of any blame for this summer’s financial turbulence.

Conceding that many hedge funds and their “wealthy private or institutional investors” may have incurred heavy losses in recent months, he maintained that this was no reason for regulators suddenly to intervene.

“Financial markets function on risk. I do not criticise those who make fortunes when times are good. I’m not going to shed any tears now if there are losses,” he told the European Parliament in Strasbourg.

As MEPs debated the consequences of the events sparked off by the sub-prime mortgage crisis in the US, Mr McCreevy insisted: “As much as some people want to demonise hedge funds, they are not the cause of the difficulties in the market.”

Instead, these had been provoked by poor-quality lending, compounded by securitisation of loans in off-balance sheet vehicles, whose associated risks few understood.

It was these issues, he added, that prudential authorities and supervisors would now need to address.

The Commissioner’s dogged opposition to regulatory action was in marked contrast to the many calls from European legislators for tougher measures against financial operations that had been largely conducted outside traditional regulated markets. Led by socialist MEPs, these calls attracted support from across the political spectrum.

Ieke van den Burg, the Dutch socialist MEP, gave warning that the absence of regulation for new, highly complex financial products meant a proliferation of risks for individuals and markets. “We really have to think where these blind spots are leading to and need to look at the possibility of regulation,” she said.

Poul Nyrup Rasmussen, a socialist MEP and former Danish Prime Minister, described the financial crisis as “a wake-up call for all of us, but especially Mr McCreevy”. He challenged the Commissioner to bring forward appropriate legislation.

From the centre-right, Karsten Hoppenstedt, a German Christian Democrat member, insisted that the failure to assess the risks of the new financial instruments was the source of the crisis. He argued that hedge funds should be covered by existing EU legislation on capital requirements, risk management systems and internal controls.

While defending hedge funds, Mr McCreevy conceded that the spotlight should be turned on credit rating agencies.

He reminded MEPs that he had already criticised the agencies for being slow in downgrading their ratings for structured finance backed by sub-prime lending.

He raised the question of potential conflicts of interest when agencies advise banks on how to structure their offering to gain the best mix of ratings, while at the same time providing assessments on which investors rely.

Mr McCreevy confirmed that he would be discussing with European securities regulators and with countries such as the US how to inject more transparency into the credit rating agencies’ operations. The discussions will also investigate whether the agencies were responsible for unwarranted rating inflation for structured products.

1 comment:

Karolus said...

For the information of your readers, below is a copy of a message sent to some MEP's concerning credit rating agencies and conflicts of interest.

Sincerely, Karolus
October 2007

To the Economic and Monetary Affairs committee.

Madam Chairman,
Vice-chairmen and members of the Economic and Monetary Affairs committee,

In the current market turmoil Commissioner McCreevy is examining the activities of the credit rating agencies with a view to assessing their impact on financial markets. He has asked the Committee of European Securities Regulators (CESR) to specifically examine areas of possible conflicts of interest, such as the fact that the agencies are paid by the very institutions they rate. This matter has been raised before, and one of the lines of defence usually taken by the agencies is to remind operators and regulators that the ratings they issue always reflect the information which has been made available to them. I believe this particular affirmation to be obviously false, as illustrated in the examples outlined below.

I am raising this subject with you because your committee is launching its own examination into the activity of the rating agencies.

As a French holder of several issues of defaulted Russian government bonds presently listed on the official Paris stock exchange list named 'Eurolist by Euronext', I wish to respectfully bring to your attention the rating of the Russian Federation, which I believe provides a good example of how a conflict of interest can result in the attribution of unjustifiably high quality ratings to defaulted sovereigns, despite the agencies' full knowledge of that default.

In 1918 the Bolshevik government unilaterally defaulted on all Paris-quoted russian bonds and since then the successive internationally recognised governments of Russia have refused all contact with their bona fide creditors, in flagrant violation of accepted principles of international law.

As a holder of such bonds I am shocked to see that the three main credit rating agencies attribute an "investment grade" rating to that issuer; these agencies have been formally notified of Russia's default on these bonds, and by attributing an "investment grade" rating to that issuer these agencies are, in particular, disregarding one of their own self-imposed metrics, which is to address the issuer's willingness to pay on existing issues.

Since Russia is clearly not willing to pay (and has in fact notoriously defaulted) on the above mentioned Paris-listed issues, while it simultaneously pays both interest and capital on the Russian government bonds listed in Luxembourg, that issuer is quite clearly in "selective default", a situation which is not reflected in the present "investment grade" rating. Present and potential investors are being seriously misled.

This situation is identical to that which prevails concerning the People's Republic of China (PRC) who has also issued Luxembourg-quoted bonds and refuses to honour pre-1949 bonds held by French and US citizens.

I am taking advantage of your present review of credit rating agencies activity to bring to your attention two extremely well researched documents prepared by Sovereign Advisers, a private financial analysis and investment research firm, which highlight the obvious failings of the main rating agencies in properly assessing the PRC's rating, and the probable reasons for their conduct.

The reason I am bringing these documents to your attention is that the same reasoning can be strictly applied to the rating of the Russian Federation. The documents can be found at the following URLs:

1: (8.9 MB)

Having briefly highlighted the fact that both the Russian Federation and the PRC have been attributed erroneous ratings, not through lack of knowledge but on the contrary despite full knowledge of a "selective default" situation, I would now like to explain why, in my view, this is so.

It is public knowledge that market liberalisation in both countries has resulted in the issue of Russian and Chinese securities on international markets. In particular, Russian and Chinese private and public corporations have been borrowing in increasingly massive quantities over the past years, and the necessary rating process of each issuer (without which foreign investors would be very reluctant to lend) has resulted in massive windfall profits for the rating agencies. It is crucial to understand that it is not the custom to rate a country's private issuer better than that country's government. Thus, no Russian corporation can be attributed a better rating than the Russian Federation itself. Therefore, if the agencies had attributed Russia the rating it quite obviously deserves, i.e. "selective default", they would have forfeited a massive source of revenue and profits since a Russian issuer could not have hoped for a better rating than "selective default" and would therefore have refrained from requesting a requesting a rating, knowing that no foreign investor would be ready to lend on the basis of a "selective default" rating. Since it is the rated entity that pays for the rating, there would have been no revenue for the agencies. The same goes for the PRC and Chinese companies.

Although the matter discussed above - ratings attributed to defaulted sovereign issuers - is somewhat removed from the sub-prime mortgages and asset backed securities ratings causing the current market turbulence I believe that both matters stem from very similar conflicts of interest, that they both have a bearing on hundreds of billions of dollars of outstanding debt, and are therefore both worthy of your immediate attention. I think it relevant to remind you that in Sotchi on September 22nd 2007 President Putin confirmed a 1000 billion dollar modernisation programme, specifying that "in (his) view private investors, both national and foreign, will participate", while Mr. Ivanov, interim deputy Prime Minister, added that "additional tools will guarantee a high level of return on investment". Without a "selective default" rating, investors will be misled into believing the Russian government and its government entities honour their outstanding debt more than they actually do.

As one of the 316,000 French holders of defaulted Russian government bonds, the outstanding value of which is conservatively estimated to be in excess of US$ 90 billion (the outstanding amount owed by the PRC to US citizens being I believe in the hundreds of billions of US dollars), I respectfully urge you to include the matter of the ratings attributed to defaulted sovereigns - and specifically to the Russian Federation and the PRC - in the scope of your examinations, with a view to obtaining that by reflecting the unwillingness to pay, the ratings of defaulted governments and government entities accurately inform the investment community as to the track record of these issuers and the potential risks to which future investors will be exposing themselves, risks which at present are negated by the rating agencies in violation of their own self-imposed metrics, as is made abundantly clear in the first of the two documents mentioned above.

Thank you for your attention.