Should We Abolish Credit Rating Agencies?

In an article I wrote back in April of 2007, I assigned blame to various individuals, industries, and institutions for the financial and mortgage meltdown that led us to the current financial mess we find ourselves in. One such perpetrator has received a significant amount of flak recently, and some suggest they should be restructured or even eliminated altogether. I am speaking, of course, of the credit rating agencies, such as Moody’s Corp. (NYSE: MCO), Fitch’s, and Standard & Poors - which is owned by The McGraw-Hill Companies (NYSE: MHP).

Through further research, I compiled a list of options we have for dealing with the credit rating agencies.

Option 1: Restructure Them

In a January 3rd New York Times op-ed, columnists Michael Lewis and David Einhorn rail against the rating agencies:

End the official status of the rating agencies. Given their performance it’s hard to believe credit rating agencies are still around. There’s no question that the world is worse off for the existence of companies like Moody’s and Standard & Poor’s. There should be a rule against issuers paying for ratings. Either investors should pay for them privately or, if public ratings are deemed essential, they should be publicly provided.

Those are some pretty harsh words, Mr. Lewis and Mr. Einhorn, but as a professional investment adviser I happen to agree with you. Issuers buying ratings from rating agencies to sell investors securities is akin to an individual (issuer) buying a credit score (rating) from Experian (rating agency, who is competing with other rating agencies for business) then going to any number of banks (investors) to apply for a loan (security).

As you can imagine, the individual wants a good credit rating from Experian, and Experian desperately wants the individuals’ business, so their incentives are aligned. But what about the bank’s incentive? Their incentive is to make sure their money is safe, but they only have this Experian rating to rely on. Too bad for the bank.

Option 2: Eliminate Them

I like Mr. Lewis and Mr. Einhorn’s ideas, but I found another viewpoint that I might like even more. Financial blogger Paul Kedrosky takes it one step further and suggests that rather than restructuring these entities, we should do away with them altogether. Mr. Kedrosky correctly points out that there is no regulatory oversight for equities, which begs the question: Why don’t we just let the private investors rate these securities, like they do with equities? Sure, private investors don’t always value equities perfectly, but obviously rating agencies don’t either.

Option 3: Increase Oversight

Yuck. I don’t even want to think about this option. But if any of you think this one is a good option, please share your thoughts.

Option 4: Do Nothing

I doubt many of you think that we should do nothing. The credit rating agencies really messed up and led investors to slaughter by not recognizing (or perhaps willfully ignoring) risks in the products they rated. But again, I’m willing to hear any opinion out.

Disclosure: Freund Investing Managing Member Ryan Freund holds no position in any of the companies mentioned in this article. Freund Investing has a solid Disclosure Policy.

Comments

[Roger Knights:]

5. Set up a semi-official or official agency, or agencies, to rate the raters, years after the fact, and penalize the poor performers financially. (Maybe require Moodys, etc. to post a bond.)

Jan 06 05:32 PM

[Michael Fit...:]

The answer to your question is YES.
Moody's, Fitch, and S&P should be shut down and their principals put behind bars for their fraudulent role in the credit crisis. Had not these agencies slapped AAA ratings on repackaged junk instruments, those instruments would never have been able to have been sold. If the instruments had not be tradeable (removing the liability from the originators), then the fraudulent credit crisis spiral would never have got off the ground. But, the ratings agencies new there were billions to make by playing the game, so they played it while regulators looked the other way. I have as much use for the ratings agencies as I do for the SEC: none whatsoever.

Jan 06 06:55 PM

[Anthony Alfidi:]

Abolishing the credit rating agencies will leave credit assessments completely in the hands of a free but unregulated market - that of credit default swaps. The values of those swaps can swing wildly in a day, so rated company CFOs may be hard pressed to sell commercial paper on a particularly volatile day (absent the credit crunch, of course).

Maybe a better solution is to get the analyst community to agree to publish the agency credit ratings of covered companies together with a 90-day moving average of that firms' CDS spread. That way, the subjectivity of the agencies is balanced with a market snapshot.

Too hard to manage? Well, we could just make the SEC rate corporate credit. That would give them something to do instead of waiting for whistleblowers to show them the next Ponzi scam. ;-)

Jan 07 12:47 AM

[raytayzmd:]

...the problem is not so with the credit rating agencies...at the time they assigned their ratings, I suspect the economic circumstances supported their judgement...the real problem is the weight given to such ratings by investors...times change, the economy changes -- what was true five years ago when interest rates were low and the economy was booming were altered dramatically after the fed began raising rates a couple of years ago...credit worthiness does NOT remain constant over time...more important, however,, the ratings agencies played no part in the irrational use of derivatives to leverage postions -- positions which crashed when the ratings agencies' reassessments of bonds started an avalanche of margin calls...nope, blame the brokers forever looking for yet one more item they can package, sell and make a commission on, not the raters, for the current situation.

Jan 07 01:00 AM

[Chuch:]

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Jan 07 02:19 AM

[BlueOkie:]

No one was complaining when the markets were going up. Investing is about risk and reward. If you cannot handle the downs you shouldn't be investing.
Markets are not about today's price as much as what they'll be in 5 or 10 or 20 years.

Jan 07 09:27 AM

[biomedlives:]

I agree with raytayzmd that brokers packaging, selling, and getting commissions on debt securities contributed significantly to the current mess. In that regard, I believe that regulations should require the originator of a mortgage or package of mortgages to own a significant fraction of it until maturity or refinancing.

If rating agencies continue to exist, it might be useful to require each one to report periodically the number of changes in its ratings from six months or a year ago. Minor changes would be ok, in my view, but changes from AA to CCC would represent failures of analysis on an agency's part.

Jan 07 10:35 AM

[gdh:]

When you think about the process, it's pretty clear that Moody's, S and P, et. al, serve no utilitarian or investor purpose. They are paid by the issuer, which means that their ratings dictate who may buy the issues, It's the dumbest system possible. Ask any company that relies on the highest rating possible (insurers) what happened when they took the conservative route in 2006 and 2007. In a few cases, (MTG, ABk), they were actually threatened by their balance on the balance sheet, no ALT-A was negative. These agencies have done more damage than any serivice industries. They may have a Buffett put, but common sense says abolish them and start from scratch. Buyers will find the best credit analysis, but given the rewards of a AAA rating, there probably has to be some governmental agency that either rates or oversees raters that give the blessed AAA.

Jan 07 01:22 PM

[Ryan Freund:]

GDH - I agree completely. It's rediculous.

Biomed - I have heard about the idea of forcing the originator into holding part of the debt issued, and I think that's a solid idea. As for requiring each rating agency to report periodically the number of changes in its ratings from six months or a year ago... who would review that, and what punishment would come for failure? I simply cannot see the purpose of having these institutions around anymore.

Jan 07 01:59 PM

[bondboy:]

Ok, so the agencies got egg all over their collective faces for failing to model the full potential for the real estate crash (and failing to model in some $20 billion of bogus marks by Lehman on its real estate related assets); all of which tarnished their collective reputations. However, the agencies in aggregate employ roughly 2,000 (maybe 3,000?) securities analysts engaged in rating many thousands of different pieces of paper issued by thousands of corporations and political subdivisions around the world, in addition to more than 100,000 individual pieces of structured loans. Overall they do a credible, if quite unspectacular, job. Getting rid of the agencies would seem to just make make it a lot tougher and more expensive for the vast majority of (if not all) borrowers to tap the public markets. Of course, the capital markets could just continue to migrate away from New York, perhaps to London where ratings seem unlikely to be outlawed.
It does not appear that any of the authors in the articles cited have any serious bond market experience.

Jan 07 03:59 PM

[Ryan Freund:]

Bondboy,

You didn't cite any specific reasons why bonds can't be rated the same way equities are: the free market. You also failed to justify the fact that the incentives of the rating agencies are, in fact, at odds with the investing public (which they're supposedly serving).

Jan 07 05:05 PM

[bondboy:]

You ask 'why bonds can't be rated the same way equities are: the free market?' Well the short answer is that they already are and have been for many decades! All larger sell side firms employ scores of bond analysts who make very lucrative careers out of second guessing the agencies' ratings; such analysts research is typically available to the firms' institutional bond customers. Aside from the institutions being bombarded with sell-side bond research, such institutions employ a huge number of bond analysts doing research in house. As to the rating agencies themselves, the SEC's "nationally recognized" list totals around 10 outfits, at least three of which appear to exclusively use the "investor pays" business model. The difference between the major rating agencies and their sell-side, institutional, and "investor pays" competitors, is that most competitors tend to cherry pick the market, focusing on only the largest, most actively traded bond issues and issuers, and ignoring most of the market. As to your second point, the conflict inherent in the "issuer pays" model has been debated for at least the past 35 years and will probably be debated for the next 35 years. It is the same conflict faced by the accounting profession; shall we do away with audited financial statements? I don't mean to say there is no potential for conflict, but I never once saw it happen. On this latter point, making errors in analysis does not count; indeed, the openness (transparency) of S&P and Fitch in 2007 in fully revealing their real estate asset price risk assumptions in their structured bond rating models allowed sharp non-agency bond analysts having a more negative view of such assets to literally make billions of dollars. Bond market participants like having research and ratings from the major agencies for two reasons: (1) it's a place to start for their own analysis and (2) the agencies cover the waterfront, including obscure issues and issuers on which nobody else wants to spend time or resources. So I'll end today's lesson where I ended the last one: none of the authors of the articles cited appear to have any serious bond market experience.
(Lewis spent six months as a trainee at Salomon Brothers 20 years ago, but he got the rating symbols for commercial paper wrong in his NY Times article - he get's an "F") It's just irresponsible for people having no serious experience or credentials to be calling for someone else's head.

Jan 11 12:02 AM

[Ryan Freund:]

"As to your second point, the conflict inherent in the "issuer pays" model has been debated for at least the past 35 years and will probably be debated for the next 35 years. It is the same conflict faced by the accounting profession; shall we do away with audited financial statements?"

No, we shouldn't. We rely on folks like PwC to look at the things we cannot look at (such as internal controls over data) and make a decision as to whether or not they cooked their books. The difference is that all the data PwC looks at is mostly private, whereas all the data the rating agencies look at is public. Can I go look at a company's security policy and determine whether segregation of duties exists within individuals access over financially significant - and bottom line affecting - data? No. Can the market make the determination over whether a bond should be rated AAA or AA? Yes. Not perfectly, but at least the incentives are aligned.

And in a perfect world, we would do away with financial auditing, it's just not feasible. Take a look at Satyam.

Jan 11 11:56 AM

[bondboy:]

It's been a while since I worked at a rating agency, but we were privy to non-public data from virtually everybody we covered.


On Jan 11 11:56 AM Freund Investing wrote:

> "As to your second point, the conflict inherent in the "issuer pays"
> model has been debated for at least the past 35 years and will probably
> be debated for the next 35 years. It is the same conflict faced by
> the accounting profession; shall we do away with audited financial
> statements?"
>
> No, we shouldn't. We rely on folks like PwC to look at the things
> we cannot look at (such as internal controls over data) and make
> a decision as to whether or not they cooked their books. The difference
> is that all the data PwC looks at is mostly private, whereas all
> the data the rating agencies look at is public. Can I go look at
> a company's security policy and determine whether segregation of
> duties exists within individuals access over financially significant
> - and bottom line affecting - data? No. Can the market make the determination
> over whether a bond should be rated AAA or AA? Yes. Not perfectly,
> but at least the incentives are aligned.
>
> And in a perfect world, we would do away with financial auditing,
> it's just not feasible. Take a look at Satyam.

Jan 11 04:48 PM

[gdh:]

If you mean credit rating experience, you're right, most of us don't have it, and if we did, we certainly wouldn't admit it. If you were wrong by an A, i.e., AAA versus AA, who would begrudge you, but you're wrong by three A's and a couple B's. What do you rate GE today? What do you rate California today? What do you rate the remaining brokers, big insurers and emerging market sovreignties? The rating agencies should be flushed. They couldn't have done a lousier job, particularly after botching Enron, Worldcom, Adelphia, et. al.


On Jan 07 03:59 PM bondboy wrote:

> Ok, so the agencies got egg all over their collective faces for failing
> to model the full potential for the real estate crash (and failing
> to model in some $20 billion of bogus marks by Lehman on its real
> estate related assets); all of which tarnished their collective reputations.
> However, the agencies in aggregate employ roughly 2,000 (maybe 3,000?)
> securities analysts engaged in rating many thousands of different
> pieces of paper issued by thousands of corporations and political
> subdivisions around the world, in addition to more than 100,000 individual
> pieces of structured loans. Overall they do a credible, if quite
> unspectacular, job. Getting rid of the agencies would seem to just
> make make it a lot tougher and more expensive for the vast majority
> of (if not all) borrowers to tap the public markets. Of course, the
> capital markets could just continue to migrate away from New York,
> perhaps to London where ratings seem unlikely to be outlawed. <br/>It
> does not appear that any of the authors in the articles cited have
> any serious bond market experience.

Feb 02 10:21 PM

[EarthMars:]

I think think the credit bureaus should be eliminated entirely. I despise the credit rating system because it equates people with no established credit history to people with malignant credit history. This makes it hard for young people like myself to own a home. Banks now expect people to rent a home for a couple years before they can get a loan to buy one. No one should have to rent a home if they can already afford the downpayment to buy one. I can understand if someone has a history of failure to pay owed debts, but if someone doesn't have any credit history at all, they deserve to be looked at in a nuetral status. When trying to get a home loan without any credit history, banks look at you in a negative light, which doesn't make sense. It's like they don't understand the difference between 'no credit history' and 'bad credit history'.

If I had financed my truck when I bought it a few years ago, I would now have sufficient credit history established. But I didn't. I paid $7,500 cash for it. To think that the fact that I payed cash for my truck instead of financing it through a lender is what is now preventing me from getting a home loan is what makes me want the "credit rating system" to be abolished completely.

I have a steady job and I have the money saved up for a 20% downpayment on the house that I want to buy, yet because some "Credit Bureau", which is really just a private agency, not a public or government funded one, doesn't have my history on file, I can't proceed with establishing a home for myself.

Jun 20 08:33 AM