The Easy Solution to Ratings Conundrum

May.17.10 | About: Moody's Corporation (MCO)

I was gobsmacked by the link that Misha Bloom put on one of my articles; you have to look at this.

Outside of the inspirational humanity of Hans Rosling, he has an important idea, which is that there is a lot of data around, much of it collected by publicly funded organizations that is not being made available to the public.

I’m not the only person to say that the main reason for the credit crunch and the subsequent collapse of the fiat financial system (including the Euro) was mainly because of the rating agencies.

I was interested to see that Nobel prize winner Joseph Stiglitz called the Ratings Agencies one of the key culprits of the credit crisis.

I agree with Matt Yglesias that the conflict of interest argument, just doesn’t wash.

The point that I have been trying to make for some time is that it’s not hard for an investor to do his own due diligence on a security, except that the data is not available in the public domain.

Instead, investors are fobbed off with ratings, and as we have all seen, ratings are not a very reliable benchmark for quality, whether you are talking RMBS, or CDO, or Sovereign Debt.

Which is why the buyers of securities are currently on strike, and the only people buying anything remotely suspect are the Fed (via TALF) and latterly the ECB (even though Jean-Claude Trichet was until a few days ago adamant that would never happen).

The solution is not to either beat-up the rating agencies, which the SEC is trying to do by throwing fluff at them, or to tinker with the system. The solution is to acknowledge that there are TWO interested parties in this Jacuzzi.

1: The government, the regulators and the central banks want to have a basis for making decisions on what the risk weighting is for a particular security, when they calculate capital adequacy for the participants in fractional reserve lending.

The current system is that they handed out concessions to ratings agencies to do that work for them, except the ratings agencies don’t work for them, they work (mainly) for the people selling those securities.

A better solution would be that if the gate-keepers of the fiat currencies want ratings agencies (or anyone) to tell them anything about the quality of the assets in their “system”, they should hire them directly.

2: The other “market participants” who care about the quality of securities are the buyers. They are traditionally pension funds and insurance companies, who have predictable long-term liabilities that they want to cover with predictable long-term income streams (and if they don’t want, they are obliged to hold a proportion of “investment grade” debt (nowadays called toxic assets), because the regulators and central banks mandate that (which was one of the reasons for the explosive increase in demand for AAA toxic assets from 2000 to 2007).

Outside of complying with the silly regulations that forced them to buy assets that they might have preferred not to (in particular, the ones that are now worth 10 cents on the dollar if they are lucky), the “buyers” ARE concerned with quality.

In the past, many stupidly relied on the ratings attached to the securities. The reason that was stupid is that in the fine print of any rating it says (in very small writing), something along the lines of:

THIS IS AN OPINION AND THE BUYER MUST DO HIS OWN DUE DILIGENCE.

Why was there a credit crisis?

Simple, no one read the small print.

The problem then (which was where the morons who bought all that toxic garbage went wrong) and the problem now (which is why no one is buying anything except US Treasuries), is that the data you need to do a proper valuation of an RMBS or a CDO or Sovereign Debt, is simply not available, either to the sort of “well informed institutional investor” who got gamed by Goldman Sachs (NYSE:GS) and John Paulson, and most certainly not to your average Joe.

This is a point I have been making for ages, it’s one of the main reasons I started writing blogs in September 2008, for examples click here and here.

The point is, if given the data then anyone who can figure out how to do multivariate regression analysis (it’s not hard, just buy a copy of SAS JMP and click on things at random) can do his own valuation of even a CDO, in his garage.

Mandate that data is put into the public domain, in a format that allows the average Joe to analyze it, and the only use anyone will have for a ratings agency is the regulators, who decide capital adequacy risk weightings.

Disclosure: No positions