Blaming the Ratings Agencies: Too Convenient

Many finger the ratings agencies for a portion of our current problems, and to be sure, they deserve blame. Many of the recommendations call for eliminating the opinions of the ratings agencies from anything that might determine regulatory capital levels. Let the regulators do it themselves, instead.

That’s a nice dream, or, for those in the insurance industry, a nightmare. The insurance industry survived such an institution, the NAIC Securities Valuation Office, and lived to tell of it.

It is said that if you can’t get work as a credit analyst, go work for the rating agencies. They always need people, because the competent would never stay around due to low pay. Well, the NAIC SVO was if anything worse, and for those of us that interacted with it, we had no sorrow when they moved to the rating agencies. In terms of speed, much better. Even the opinions were more intelligent.

I’m not saying that the rating agencies didn’t make errors; of course they did. Most often it was over asset sub-classes that were new, and had never been through a bust cycle. They would always be too optimistic.

Now when the regulators blame the rating agencies, it is all too convenient. Why not blame the regulators? They can ban any asset class that they hate; in the past, regulators typically banned assets until they were seasoned enough for institutions with trust obligations to buy them.

The rating agencies typically did well rating asset sub-classes that had experienced significant failure at some point in the past. Ranking corporate bonds and corporate loans against each other — no one should argue that they did a bad job rating them in aggregate. Structured products are another matter, and the rating agencies, through their conflicts of interest, got sucked into the boom-bust cycle.

With that, I put it back to the regulators. You don’t want to depend on the rating agencies? Fine, create your own rating agency, and staff it with top talent. Wait, you can’t afford that? Okay, staff it with people that could work for the rating agenices. You can’t afford that either? Ugh. Well, at least, limit your goals, and tell those you regulate that they can’t invest in complex products that you can’t understand and rate. Wait, you’re getting pushback from politicians telling you that you’re killing those that you regulate? Tell them to jump of a cliff. Wait, they are suggesting the same to you?

Now, many argue that a rating agency run by the regulators would be insulated from influence from Wall Street. It’s not that easy. If the ratings have a dominant effect on whether securitizations get done or not, you can bet that Wall Street will call to solicit their opinions in advance of issuance. Once the ground rules are set, Wall Street will lobby the analysts, showing much the same approach that they did with the private rating agencies, in order to get them to change/loosen their opinions. (I experienced this with the NAIC SVO; they would usually fall in line with the private rating agencies, because it made their life easy.)

I am not a defender of the private rating agencies as much as an explainer that it is difficult to avoid the problems that they face. The problems exist in any situation where a third party tries to analyze a wide number of credit relationships.

This is why I am skeptical in the long run of any effort to replace the rating agencies by the regulators. As a challenge, I say “Go ahead, try it. Past efforts like this have failed, and you will as well.” I say this not as a lover of the private rating agencies, because they have done me wrong as well. The problems of the rating agencies are endemic to any third party evaluation of credit. Better to be wise to their biases as an institutional investor, and avoid their weaknesses, than to be naively credulous, and complain that you got cheated because a rating was too high.

Comments

[E Thomas St.:]

Mistakes were made? The obvious problem here isn't that mistakes were made, it's that mistakes were made and no one at the rating agencies is held accountable for something that was obvious back in 2006 to anyone who has seen bubbles before.

The only way they've received their share of culpability in enabling the whole mess is that many people, myself included, don't trust rating agencies at all. That lack of trust is good for the system how?

Jan 07 11:50 AM

[who:]

Why are rating agencies needed? Clearly they didn't understand product which they rated. Sad fact is they act as business as usual.

Jan 07 12:58 PM

[Crocodilian:]

Why have ratings at all? The market trades debt, the levels that debt trade at are much more indicative of creditworthiness than ratings.

Take GE. If you go by the ratings, GE's is and has been a AAA credit. That's not the way their debt trades, though. So which do you believe, the rating or the market? I believe the market.

Jan 07 04:57 PM

[Ryan Freund:]

"With that, I put it back to the regulators. You don’t want to depend on the rating agencies? Fine, create your own rating agency, and staff it with top talent. Wait, you can’t afford that? Okay, staff it with people that could work for the rating agenices. You can’t afford that either? Ugh. Well, at least, limit your goals, and tell those you regulate that they can’t invest in complex products that you can’t understand and rate. Wait, you’re getting pushback from politicians telling you that you’re killing those that you regulate? Tell them to jump of a cliff. Wait, they are suggesting the same to you?"

No, don't create a new agency. Let the free market be the "rating agency" just like it is for stocks. Why is this so hard to understand?

Jan 07 05:11 PM

[bondboy:]

Now retired, I spent the better part of 30 years in the bond business, largely splitting my time between first one of the agencies and then a major sell-side firm. Yours is about the sanest, most thoughtful comment I've read on this subject. Nonetheless, as to the conflict of interest argument, I'll take a modest exception; if the argument were valid, it should have shown up in corporate and muni ratings at some point in the past 35 years - it simply hasn't, at least not in any statistically significant fashion. I think the agencies' aggregate failure in the mortgage-related/CDO area is quite simply a failure to anticipate the full potential of the real estate crash; the modelers had nothing in US history - not even the Depression - on which to hang their hats. That's not an acceptable excuse for blowing the analysis - which they did by being strictly backward looking, but the conspiracy theory stuff strikes me as misplaced.

Jan 07 07:33 PM

[Tradememe:]

The problem is that there is an inherent conflict of interest. The rating agencies are being paid by the institutions that are being rated. So, it is not easy to downgrade your own paying customer.

Jan 07 11:19 PM

[Steven Hansen:]

we have an problem in that:
- it is impossible for an investor to perform due diligence.
- the government has historically been a piss poor regulator.

in shipping, the rating agency is the insurer also - they are putting their wallets where their mouth is.

Jan 08 12:58 AM

[Smarty_Pants:]

"in shipping, the rating agency is the insurer also - they are putting their wallets where their mouth is." - The hand

That sounds like it puts the incentive in the right place. Have the raters ever been financially obligated to back their ratings in any manner before? Is it possible to change the way ratings are done so that the rating agency has money riding on their work too?

Perhaps a tiered fee structure with the max fee posted into an escrow account by the issuing agent, where portions of the fee are released during the life of the product, or returned if performance is much worse than the original rating? The higher fees would allow the rating agency to hire better talent unless and until their ratings were shown to be subpar.

Just an 'outside the box' thought. I don't have much in the way of experience in the entire process, but the problem is an interesting one.

Jan 08 09:16 AM

[BerkeleyBob:]

I have said it before, but will repeat. AIG was not an insurance carrier but an unregulated off shore bookie. The rating agencies aided and abetted the sale of fraudulent CDO's and other instruments, sold primarily to foreign central banks and institutional fiduciaries to the irreparable damage to America's reputation in the international financial market. The rating agencies did not understand the nature of the CDO's and did not perform reasonable diligence to determine the value of the underlying sub-prime mortgages. The "complexity" of the transactions were strikingly similar to the exotic terminology used by the Enron energy traders. The crisis created is now multi-national in scope.

Jan 08 03:29 PM