In Defense of the Rating Agencies, Once Again

I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies. Those who want historical context can read my earlier three pieces:

• In Defense of the Ratings Agencies
• In Defense of the Rating Agencies — II
• In Defense of the Rating Agencies — III

And let me repeat my five realities:

• There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
• Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves. The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies. The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
• New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
• Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
• Ratings can be short-term, or long-term, but not both. The worst of all worlds is when the ratings agencies shift time horizons.

First, please understand that institutions own most of the bonds out there. Second, the big institutions do their own independent due diligence on the bonds that they buy. We had a saying in a firm that I managed bonds in, “Read the writeup, but ignore the rating.”

The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line. They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles. They know that ratings are just opinions, except to the extent that they affect investment policies (”We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument). Now, sophisticated investors knew that AAA did not always mean AAA. How did they know this? Because the various AAA bonds traded at decidedly different interest rates. The more dodgy the collateral, the higher the yield, even if it had a AAA rating.

My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit. Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same. Early in the 2000s, sophisticated investors got burned, and learned.

That is why few insurers have gotten burned badly in the current crisis. Few insurers bought any subprime residential securitizations after 2004. But, unsophisticated investors and regulators trust the ratings and buy.

Recently, the rating agencies have lost some preliminary arguments in a court case where a defense they made that ratings are free speech has been shot down. I must admit, I never would have made such an argument, because it is dumb (See Falkenstein’s logic on the matter). People and corporations cannot say what they want, and say that they are immune from prosecution because of free speech. Fraud, and implied fraud from speech is prosecutable.

But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument. A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.

Instead, they do some qualitative comparisons to similar but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden. Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique. As it is, when liquidity declines and leverage follows, all manner of errors gets revealed. Gaussian copula? Using default rates for loans on balance sheet for those that are sold to third parties? Ugh.

But think of something even more pervasive. For almost 20 years there were almost no losses on non-GSE mortgage debt. How would you rate the situation? Before the losses became obvious the ratings were high. Historical statistics vetted that out. No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed. In this case both raters and investors have had their heads handed to them. And so it is no surprise that the rating agencies have no lack of detractors:

• Moody’s, S&P May Face More Disclosure, Liability in SEC Rules
• SEC Looks to Prohibit Flash Trade, Curb Raters
• Debt Raters Have No Place in Brave New World: Alice Schroeder
• Anschutz Sues Bond Raters, Banks Over Auction Rate Securities (poor guy. Did he read the extensive risk factors in the prospectuses? The risks were revealed.)
• Cramer: Clamp Down on Credit-Rating Agencies

I may attend a meeting this Thursday on the rating agencies and the insurance industry, if my schedule permits. If I get a chance to speak, I hope I can make my opinion clear in a short amount of time.

As for solutions, I would say the following are useful:

• Competition (yes, more rating agencies)
• Compensate with residuals and bonuses (give the raters some skin in the game)
• Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
• Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).

In economics, where there are more than two players, easy solutions are tough. I only ask that solutions to the rating agency difficulties be reasonably certain that they do not create larger problems. Ratings have their benefits as well as problems.

Disclosure: No economic interest

Comments

[Mad Hedge F...:]

bd s The case against the Big Three rating agencies took another step forward when a New York judge threw out the freedom of speech defense for one of the complaints. Terry McGraw, CEO of McGraw Hill, and owner of defendant Standard & Poor’s, says that at the peak in 2006, the industry was prepared for a worst case scenario of a 15% draw down in real estate prices over 18 months on the local level. Instead, it got a 50% national plunge that is now two years old and aging. It didn’t help that a Moody’s analyst wrote an e-mail saying he would rate paper issues by “cows.” In the race for market share, Moody’s, S & P, and Fitches’ competitively devalued the meaning of “AAA” so that even the most toxic subprime sludge came out highly rated. With their seals of approvals, the agencies became the facilitators-in-chief of the over lending and over borrowing that made the crash a mathematical certainty. The hedge funds that made billions wisely ran their own in-house ratings departments which thought otherwise. They fell down on their knees, thanking God that inflated “independent” ratings led to wild over valuation of debt securities and set up some of the greatest shorts of the century. There is no Hell hot enough to make ratings agencies adequately pay for their deliberate misdirection of trusting investors. As for the hedge funds, their new short play is the one rating agency that is still publicly traded, Moody’s (MCO).

Sep 22 10:55 AM

[djackson:]

I know of quite a few insurance companies that got burned in securitized product along with quite a few "sophisticated" investors or pension and mutual fund money. The 'smart' money did not avoid all this. Will be fun to watch the next installment when all the CRE loans originated in '06 and '07 that were stuffed into CMBS need to be refunded.

Not sure your correct that investors can't bear the freight of everything a rating firm does. That seems to be the way Egan Jones operates and there are other services like CreditSights which, while not formally rating agencies, provide insight for a fee.
They might be more prevalent if a government imprint was not given to the likes of Fitch, Moodys, and S&P. Come to think of it, they already charge investors to get much of the information behind the letter rating.

What appears egregious this time around is the extent to which the rating agencies employees seemed to know their ratings were questionable and the degree they appear to be driven to generate fees at any cost.

Sep 22 11:17 AM

[Thomas J. G...:]

David has knowledge of this industry but I disagree with him here. If I worked for one of these rating agencies in a position of power there is no way that I would have allowed any vehicle that involved personal mortgages to be triple a rated. Human behavior towards a mortgage is unpredictable, real estate markets are volatile. When packaged mortgages came into vogue the max they should have been rated is a high b at the most (I said this at the time they were getting rated trip a). A little common sense would have avoided a lot of trouble.

Sep 22 12:23 PM

[notsosmart:]

greed & common sense-oil & water.

Sep 22 12:59 PM

[VK9141:]

A worthwhile argument given many peoples hasty judgements against.

At the end of the day, whilst I personally think the agencies massively screwed up, we let them!

We still need them, and most of what they do they should keep doing. The rest big changes are needed to align everyone's interests.

Sep 23 05:51 AM

[Moon Kil Woong:]

Ratings agencies would have a better leg to stand on using the author's argument if they weren't so fiscally entrenched to those they rate for their income.

I agree that there should be those that can rate companies without incurring lawsuits from companies that issue bonds, debt, and other securities. Sadly, ratings agencies don't take advantage of this. They are more andriot at avoiding lawsuits against those who lost money because they don't disclose real risks.

I agree rating bonds with derivatives attached to them is hard. After all, how is anyone to know AIG couldn't make good on $3 trillion in mortgage derivatives. Or for that matter, who actually can pay the $600 trillion more derivative exposure still in the market. The total US is only worth $60 trillion folks. The plain truth is, ratings agencies are in the business of peddling securities through half baked truths, not finding and disclosing facts.

If only accountants could be the same way. i suppose that's why lobbyists keep asking Congress to pass bills watering down already watered down accounting disclosures. When you buy a bond be wary. They are vetted a lot less than securities, and thus may be more risky than the stock market that many accuse of being a cowboy casino. Scary.

Ratings agencies need real reform. And I don't mean the government sponsored reform recently proposed to create a agency in thrall to the government so they can force them to rate all US government debt as AAA forever.

Sep 23 06:08 AM

[Steve B. Wise:]

Moon brings up a good point, but in all honesty it just seems hard to get people in any financial field to do an honest day's work. Why should a regulator care whether a bond is rated accurately when he is paid for issuing ratings, not necessarily the accuracy or quality of those ratings.

Further, as the author correctly suggests, how is a regulator to judge securities in doomsday scenarios along the lines of last September? Any regulator that did would be accused of being a 'Chicken Little' for drawing conclusions based on (what at the time prior to last September) were considered implausible scenarios.

The real issue comes back to something Moon brings up. The people who NEED the accurate ratings (investors) aren't willing to PAY for them. Instead the banks need a 'ballpark' figure to work from in order to be able to price and sell the offering to the public. Given the enormous fees at stake, banks NEED ratings that allow them to profitably sell the bonds. So they "buy" good ratings and unload the crappy bonds on the non-diligent public.

And we think this is news?

Sep 23 09:53 AM

[Larrysyr:]

I don't agree, David.

Private rating agencies achieved a semi-official place as arbiters of value in our financial markets. Regulators then accepted their ratings at face value and used them to decide which securities banks and other regulated enterprises could invest in.

Turned out that rating agencies were motivated by profit first, not by honesty. They violated their own operating principles and made themselves superfluous. In fact, I would argue that by assigning investment grade ratings to sub-prime MBS, they probably contributed to a massive fraud.

I have a simple solution. Strip all 3 agencies of any semi-official status, and invalidate all loan and regulatory covenants related to their ratings. (I'd actually officially disbar them from the business of issuing ratings to accomplish this.)

Start fresh. Any investor who wants a rating on a security needs to find someone they believe is reputable to do the analysis. Any investor who doesn't need a rating (all those institutions David refers to) will do their own due diligence.

Sep 23 11:36 AM

[Jeff Nielson:]

There is NO "defense" for these companies.

I just wrote a new piece today on these fraud-accomplices ("U.S. ratings-fraud continues" www.bullionbullscanada...).

In that piece, I pointed out the following:

Shortly after the Wall Street Ponzi-scheme collapsed, these "ratings" agencies admitted that they never even HIRED ENOUGH STAFF to independently evaluate these "financial products" (i.e scams).

This means they were NEVER actually performing the function of a "ratings agency" (i.e the INDEPENDENT assessment of risk/creditworthiness). This means they have NEVER been anything other than accomplices in fraud - through "rubber-stamping" Wall Street fraud.

The argument that investor fees are "insufficient" to pay the costs of "rating" these products obviously has ZERO merit - when even though they are getting fat fees directly from Wall Street, they STILL haven't been doing their jobs.

Obviously, products which are too convoluted (and thus too expensive) to rate should simply be labeled as "unrated" - since that is already the TRUTH. Then let's see how well the Wall Street banksters can scam investors, when they have no "AAA" rubber-stamps to delude buyers.

It would force Wall Street to sell products which investors (and the ratings agencies, themselves) could actually UNDERSTAND.

This is what the Wall Street crime syndicate (and their accomplices, the ratings agencies) are REALLY fighting against.

Sep 23 12:57 PM

[Tom Shohfi:]

Before mass-securitization and the rise of CDOs, the rating agencies integrity was based on the credibility of due diligence behind their debt ratings. When they destroyed the meaning of those ratings by hastily slapping seals of approval on garbage CDO, CDO^2 and other products, that integrity disappeared and their biggest cash cows have been crippled beyond repair. Moody's and S&P have been trying to diversify their business models because they know the game is over.

This process was in effect before securitization. Corporate bond prices predicted ratings changes long before they actually occurred. The ratings system had been made obsolete by market efficiency. We already have the mechanism to eliminate the role of ratings all together: credit default swaps. With a liquid, well regulated CDS market priced on an exchange to mitigate counterparty risk, periodic spread averages can be used to determine credit quality more accurately and efficiently than through the antiquated rating agencies model. We can use one of the culprits of the financial meltdown to make credit markets more stable and functional without the nonsense of "traditional" credit ratings.

Sep 23 01:19 PM

[bottoms-up:]

All I can say is that Congress had better watch out...

The rating agencies may decide to give the U.S. Government the rating they are worth!

Sep 23 01:48 PM

[Kinabalu:]

"For almost 20 years there were almost no losses on non-GSE mortgage debt. How would you rate the situation?

David, you well know that the mortgage debt in 2006 didn't look at all like the mortgage debt 20 years earlier. Early in the cycle it consisted of conventional 30-year fixed amortizing mortgages, later we had interest-only loans with a balloon payments, and, finally, we had negative amortization loans. Hyman Minsky describes this final example as a ponzi unit because the loan can only be repaid if the value of the collateral goes up. Somehow the rating agencies allowed issuers to create AAA securities out of ponzi units. This was "rating" with your eyes closed.

Sep 23 02:04 PM

[Tony Daltorio:]

The ratings agency are part of the cabal that enriches themselves on the back of "suckers" - investors of all stripes.

There is NO excuse for their behavior. They let money control their decisions. They should have said - "hey, this stuff simply cannot be rated." But that honesty would have cost them millions.

Sep 23 02:54 PM

[Mr. Mylo:]

I don't agree with David either, but your simple solution (re: dissolving contractual obligations linked to their ratings) is draconian and almost certainly illegal. The rating agencies, much like Fannie and Freddie, went amok due to profit-seeking over public purpose. No questions there. Then again, neither group is truly a public organization.

If they are abolished, then that puts the burden of proof on the individual investor to investigate each security on its own merit. I don't see that happening.

Institutional organizations have staff to make their own credit reports. Individuals primarily rely on the work of others.

On Sep 23 11:36 AM Larrysyr wrote:

> I don't agree, David.
>
> Private rating agencies achieved a semi-official place as arbiters
> of value in our financial markets. Regulators then accepted their
> ratings at face value and used them to decide which securities banks
> and other regulated enterprises could invest in.
>
> Turned out that rating agencies were motivated by profit first, not
> by honesty. They violated their own operating principles and made
> themselves superfluous. In fact, I would argue that by assigning
> investment grade ratings to sub-prime MBS, they probably contributed
> to a massive fraud.
>
> I have a simple solution. Strip all 3 agencies of any semi-official
> status, and invalidate all loan and regulatory covenants related
> to their ratings. (I'd actually officially disbar them from the
> business of issuing ratings to accomplish this.)
>
> Start fresh. Any investor who wants a rating on a security needs
> to find someone they believe is reputable to do the analysis. Any
> investor who doesn't need a rating (all those institutions David
> refers to) will do their own due diligence.

Sep 23 05:21 PM

[dw57:]

not sure why he mentions bonds since the majority of the junk is securities. and if we can't depend on them to do their task then why do they exist? and then all of the banks would have to do all the same work themselves (sounds like they would invent them if they didn't exist. and pay it as a group. but not likely to happen) to convince regulators that their capital was real. which was the point of the ratings agencies to begin with to have a unbiased 3rd party review the securities (etc) as capital, but the payola scam makes them biased (since they ended up letting those who were selling the 'assets' to actually do the work. its like letting some one who sells you gold to measure it for you. with their weights. that they take with them. what are the odds that there might be fraud?)

Sep 23 05:37 PM

[dw57:]

and i guess if we can't trust them, then it devalues their ratings. and devalues any thing that some body else ever wants to sell. thats the long term impact of this mess. in addition the credibility the rating agencies had with the regulators is probably shot. that will be extra pain for the banks going forward

Sep 23 05:42 PM

[a fat panda:]

"I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies."

I guess you are a blithering idiot to defend these people more than once. While there is no way to get investors to pay full freight for the sum total of what the ratings agencies SHOULD do, the rating agencies didn't do what they were suppose to do. Oddly enough you point out this discrepancy yourself when you say that insurers ignored the AAA rating.

"But think of something even more pervasive. For almost 20 years there were almost no losses on non-GSE mortgage debt. How would you rate the situation?"

When you drive, you look in the rear mirror, you don't stare at it oblivious to the 18 wheeler driving straight at you. Why the hell would use historic data, when the financial landscape has completely changed. The changes in DTI and LTV and the use of new loan types would suggest that you not weigh the historic data as heavily. When median home values hit 14 times median income you have a problem telling me that 6 years ago the default rates were low. The default rate was low because we were in an unsustainable housing bubble. The only problem was that the rating agencies were paid by borrowers to ignore common sense.

Sep 23 07:16 PM

[Mbuna:]

Okay, first let's take away the myopic narcissistic viewpoint all too typical of someone who has clearly been smoking the financial crack pipe for a bit too long. Don't be offended-there are probably a million others just like you. The financial world is NOT the center of the universe but for too many people it has become a black hole which has warped their thinking in the same way that a real black hole warps time.

So let me put it very simply and clearly- what you are advocating here is the massive fraud that has gone on be continued. You are even saying, somehow, that is necessary and good!? You even think you are completely sane saying this. I think you need to go to a rehab clinic of some kind because this is lunacy. In your view the law must kneel before the financial world out of necessity. You may know the bond market and its foibles but you have lost any vision of the bigger picture. Put down the financial crack pipe please.

Sep 24 04:13 AM

[Carlos Lam:]

"Competition (yes, more rating agencies)"

I wholeheartedly agree with the author on this point. The agencies themselves and the government are to blame for the lack of competition, though, seeing as how the feds have designated only three of them as the ones whose ratings they will recognize.

Sep 24 05:32 AM

[Larrysyr:]

Abolishing the rating agencies would slow down the pace of financial innovation. Investors were lulled into thinking the exotic MBSs were safe because they carried the stamp of approval of the agencies, who were assumed to have done legitimate analysis of the securities. Turned out the raters had little more clue about the risks of these securities than the investors themselves. The stamp of approval turned out to be worthless.

Investors taking risks need to take responsibility for those risks. The agencies provided the false security of a AAA short-cut around those responsibilities. I believe that the very existence of these ratings greatly enhanced the magnitude of the housing bubble and subsequent crash.

My proposal seems draconian, but the offenses were egregious, and the fallout close to catastrophic. The consequences for the agencies should match their offenses; thus they should be prohibited from issuing any more ratings.

Whether my proposals about loan covenants are legal or not, I have no idea. There is ample precedent for summarily cancelling property and contractual rights. For instance, the USA fought a bloody civil war over the question of whether slaveholders had legitimate rights to own other human beings. Less drastically, bankruptcy judges routinely cancel or alter contracts, a practice accepted as normal.

We agree that the rating agencies acted badly. My proposals are certainly on the harsh side, but my feeling is that they would constitute a just outcome.

On Sep 23 05:21 PM Mr. Mylo wrote:

> I don't agree with David either, but your simple solution (re: dissolving
> contractual obligations linked to their ratings) is draconian and
> almost certainly illegal. The rating agencies, much like Fannie
> and Freddie, went amok due to profit-seeking over public purpose.
> No questions there. Then again, neither group is truly a public
> organization.
>
> If they are abolished, then that puts the burden of proof on the
> individual investor to investigate each security on its own merit.
> I don't see that happening.
>
> Institutional organizations have staff to make their own credit reports.
> Individuals primarily rely on the work of others.
>
> On Sep 23 11:36 AM Larrysyr wrote:

Sep 24 11:41 AM