Robert Rosenkranz: Get the Rating Agencies Out of the Regulatory Process

Delphi Financial’s Robert Rosenkranz gets it exactly right in Friday's Wall Street Journal: “Let's Write the Rating Agencies Out of Our Law.” I’m trying to find much to disagree with, and am having trouble. This part is especially good:

Rating agencies employ quite ordinary mortals to analyze the credit risk of bonds, just as firms like Goldman Sachs and Merrill Lynch employ quite ordinary mortals to analyze the outlook for stocks. No one is shocked when equity analysts' recommendations don't pan out. Why should we expect any more of the rating agencies?

We should not, but the regulators have, and that is the problem. Regulators of banks, insurance companies and broker dealers have all incorporated the work of the ratings agencies into their regulations in myriad ways. Most importantly, bond ratings determine - as a matter of law -- how much capital regulated institutions need in order to own the bonds. . . .

Since the ratings determine required capital, they have a profound influence on how financial institutions invest their assets -- in effect, the regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating. [Emph. added]

If anything, Rosenkranz goes too easy on the agencies. He fails to point out, for instance, the havoc their recent arbitrary, capricious, ass-covering downgrades have wreaked on the financial system. But he’s correct to argue that the much-needed overhaul of the industry’s regulatory structure should entirely exclude any reference to the agencies and their actions. I’d go one step further: terms and covenants in lending agreements between private parties that depend on an issuer’s credit rating (or make any reference to credit ratings at all, for that matter) should be deemed unenforceable. The grip of rating agencies on capital allocation decisions needs to stop.

Ironic, isn’t it, that regulators insist financial institutions rely on the markets to value their financial assets, yet ignore those same markets in determining capital requirements for financial institutions? I have my own doubts about the wisdom of the judgments the markets seem to be dispensing these days. But the wisdom of the work coming out of the rating agencies lately has been even shakier.

The sooner the agencies lose their quasi-official status in the financial markets, the better. Rosenkranz gets the ball rolling nicely in starting the debate.

Comments

[Tom Armistead:]

Mike Callan, at the time CEO of Ambac, asked the question: "Who voted them (the rating agencies) all this power?"

Moody's in particular is aggravting: they recently did some deep thinking on financial guarantee insurance companies and concluded it is highly unlikely that there will ever again be any such thing as a triple A rated financial guarantor. One small item they left out of their article was any awareness of their own role in creating this whole sorry mess.

The practice of linking regulatory capital requirements or collateral posting requirements to credit ratings has created extreme instability and fragility in the financial system and needs to be stopped.

Jan 04 08:09 AM

[k45:]

When you pay the fox to guard the hen house, what do you expect? The issuers are paying the agencies for their ratings. That's like a home seller paying the appraiser for a valuation.

Just as laughable is the recent action on GE: Putting GE on creditwatch for a possible downgrade IN TWO YEARS! By then, GE will either be bankrupt or past the problems. I wonder if these guys drive down the freeway watching out the rear window?

Jan 04 08:21 AM

[BlueOkie:]

Do away with the rating agency. This would force people to do their own homework and have no one to blame! If you totally rely on someone else's opinion, shame on you.

The system once was everyone paid to get the information from the rating agency. It didn't work very well so we now have the person evaluated paying. They get to shop around amongst the three. Not a good answer and I'm sure we'll see some big changes. Will it be for the better?

Jan 04 08:49 AM

[User 283977:]

The rating agencies share a good deal of the responsibility for the recent financial chaos. They are the ones that rated mortgage based derivatives as investment grade instruments. Its one thing to make an honest mistake, but in this case, the fact that no one can now figure out how much those investments are worth points to a darker basis for those ratings. The rating agencies past actions and linkage / associations with investment banks and individual companies needs to be closely examined by the Department of Justice. Best case Interpretation of recent events leads to a conclusion of criminal negligence, worse case, criminal collusion, middle of the road interpretation, incompetence.

Regulatory reliance needs to be based on a rating system that is strictly independent. Investment ratings have at least two components: Objective and Interpretative. Objective aspects of ratings are mathematical, and should be capable of being automated. Different interpretations of the objective data occur because different people will differentially weight different aspects of performance and competitive data. If you have access to historical data, it seems possible that the weighting system could itself be somewhat automated. Rather than using one weighting scheme, it might be useful to provide three different weighting schemes. One a standard model for regulatory purposes. Then a conservative and a more speculative rating. Finally, ratings should be automatically evaluated for accuracy after multiple designated time periods. If a rating was found to be wrong, then its important to understand what specifically led to the inappropriate rating.

Take the mortgage based derivative securities as an example. We now know that the banks can't objectively evaluate their current value. Clearly, that means the rating agencies could not objectively value them in the first place. So those ratings were based on what evidence? Whatever that evidence was, its clear it did not provide an objective picture of those securities financial value. So what evidence did they use? We need to know that so the same mistake can't be made again.

Jan 04 10:53 AM

[notsosmart:]

is this really so hard to cure?terminate the rating agencies.the folks who pay them should stop.they will dry up & blow away.anybody trusting a rating is a fool.if they get hurt its now their own fault.

Jan 04 12:19 PM

[maz:]

Rating agencies were about as accurate as Tom Brown was on Compucredit, First Marblehead & a bunch of other financials :-)

Jan 04 05:48 PM

[speculari:]

Having watched the congressional hearings on c-span to the point of both sheer boredom and absolute fascination, I came away with the view that the only individual in the entire proceedings who made any real sense was Sean J. Egan.
Mr. Egan is the Managing Director of Egan-Jones Rating Co. & his testimony on 10/22/08 before the House Committee on Oversight and Government Reform was a real tour-de-force on the mission, history, ills, & solutions of the credit rating fiasco. I would suggest that anyone with even a small degree of interest in this subject plug his name into their browser and review his 10 pages of testimony.
However, his page one is sufficient to get the "drift" of the problems inherent in what he terms a "Partnered Monopoly" where; Moody's, S&P, and Fitch are responsible for 95% of ratings globally, and, as well, how the original business model changed in the 1970's from one where the three earned their income from selling ratings to bond INVESTORS to one that charged ISSUERS!
In any event, Egan takes a whack at just about anyone & everyone within reach on this one - be it the SEC, the Congress, NRSRO's, his competitors, or whomever! One hopes that he got the attention of the President-elect and, if properly vetted, he could be a likely candidate to head up one or another of the agencies.

Jan 06 12:55 AM

[speculari:]

k45 is right on with the fox/henhouse analogy! Again, according to Egan's testimony, Moody's profit margins at greater than 50%, are consistent with monopolistic practices and beyond! (see chart, page 2 of testimony).
This fox not only has the keys to the henhouse, he is also equipped with; a knife, a fork and, a bottle of Montrachet!

Jan 06 11:13 AM