Looking at the collapse of the hedge fund formerly known as Amaranth, we keep wondering: Just how does a rating agency (or a bank, for that matter) come up with a rating, that is, a specific probability of default or P(D), for a hedge fund?

Hedge funds are, after all, entrepreneurial entities with no capital requirements, minimal systems and controls, and a tendency to shift risk profiles through the use of highly leveraged trading strategies, sometime several times in a single day. Did we mention that the average hedge fund reconciles its books once a month?

We don't know whether or not Amaranth was rated by any of the five recognized rating organizations in the US, but we can say that the risk taken in rating the financial stability of any hedge fund is not commensurate with the fee for same. When you consider that the Congress is about to open the US marketplace for Nationally Recognized Statistical Rating Organizations or NRSROs to the benefits of competition, the problem becomes apparent.

Fact is that the existing rating agencies have been lured into the business of providing ratings for hedge funds, who naturally pay for this valuable service. The NRSROs also rate the structured transactions which hedge funds so prefer as investments. Imagine what happens to the quality of ratings, and the product spreads of Complex Structured Financial Transactions ("CSFT") based upon same, when another five or so new NRSROs hit the Street looking for business.

Even under the current regulated system, NRSROs have a history of enhancing the rating of a given subject. More important, NRSRO default scores modeling systems typically only go down to 20% default rates. This fact creates barriers to reality when the vast majority of subjects are, in fact, sub-prime.

IRA's analysis of C&I; fundamentals indicates that many more firms rated above the 20% cut are actually living in the 20-60% default probability range, what we call the "in betweens." The question for the regulators is therefore to ensure that the fundamental risk in a hedge fund is portrayed accurately. Interestingly, NRSRO ratings for hedge funds do not look at the underlying financial fundamentals of the fund, but rather purport to assess the risk that the fund's management will mess up while playing with fire. That's not the same thing.

Consider the current configuration of the world of capital finance and a Golden Triangle appears. The first leg is held down by the originating bank or broker dealer, wherefore comes the transaction concept. Second leg is the hedge fund or other "money buyer," which provides the liquidity to enable the transaction. And last but not least is the NRSRO, which rates the hedge fund and/or the transaction itself, providing comfort (or at least plausible denyability) for the buyer and support for the transaction fee.

Some time ago, The IRA asked whether the advent of Basel II Advanced Internal Ratings Based methods would put an end to the ratings monopoly enjoyed by the five NRSROs recognized by the Securities and Exchange Commission ("Will Internal Ratings Replace Outside Credit Agencies?," The IRA, February 5, 2005). Given that the US commercial banks are in full retreat regarding the expensive and challenging task of forming and maintaining internal default ratings for Basel II, it seems that the business model whereby intermediaries push the credit ratings burden onto third party specialists is alive and well.

In the past several weeks, we have heard a number of hedge fund practitioners involved in the credit derivatives market question whether or not the legs of the Golden Triangle are fully arm's length. Some have even gone so far as to suggest that when, not if, credit spreads "blow out" in the 2007-2008 period, both the dealer banks and the NRSROs which enable their art, particularly in the world of CSFTs, are going to be subject to litigation and worse when the credit and pricing decisions of the past several years unravel.

We have previously commented about the intention of US financial regulators to use the internal bank P(D) ratings gathered as part of the Shared National Credits survey to compare obligor ratings and credit exposures. Likewise, it seems apparent to us that the SEC is going to need to closely monitor the ratings behavior of the NRSROs, new and old, as the credit cycle continues to mature in coming weeks and months.

It is often commented in Washington that the top audit firms operate under the specter of operational risk catastrophe as the result of the potential liability exposure involved in auditing public companies, but what about the NRSROs? The fact of ratings for CSFTs may have already created similar or even larger magnitude operational and credit hazards, very real risks which both the dealer and NRSRO communities have yet to fully assess. Maybe the dealers will discuss same when the Corrigan Group meets at the Federal Reserve Bank of New York later this week.

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