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Why do we have credit ratings? What are the main reasons they exist?

  • To provide profits to those that rate credit.
  • To provide credit standards for regulators and creditors (shame on you, do your homework) that can’t judge credit risk.
  • To allow debtors to easily issue debt; simplifying the pricing decisions of creditors.
  • Providing quantitative and qualitative analyses of new and existing debt issues, particularly small ones where it could not be economic for an asset manager to do his own analysis.

But credit ratings don’t exist for perfection. Rating agencies are encouraged to rate new structures and new collateral types, whether they have good data or not. Regulators need a rating for any asset they allow, and new asset classes should be viewed skeptically by analysts.

Applied to the Present

The standards proposed in the current finance reform bill don’t go far enough. The existing bill allows for ratings shopping. A better way to do it would be to allow the Credit Rating Agency Board to veto ratings of those that are too aggressive. The CRAB could set real standards for structured lending, and perhaps, push back against the continued downgrade in ratings standards. There would be competition to meet the standards of the CRAB, and of the originator at the same time.

Now this could eliminate securitization, and that is not all bad. Accounting rules should not affect economic actions. If accounting rules do affect economic actions, it means there was something wrong with either or both of the starting and ending accounting rules. And better that lenders keep the results of their lending decisions. In a levered economy, it is best for lenders to eat heir own cooking; it keeps things sane.

Securitization should only exist to the degree that parties that are more willing to take on illiquidity and credit risk do so, with fair compensation for the risk that they bear. There is no free lunch; just because there is a rating, it means you should believe it?

Caveat Emptor! should be on the wall of every house and business. Let the Buyer Beware! Regardless of how many government agencies or politicians pretend to protect you, you are your own best and most reliable defender.

Do your homework, and don’t buy complex instruments that you don’t understand. Don’t buy simple instruments of simple comanies that you don’t understand.

When rates are low, we struggle to find income. Be conservative if you can be. You are your own best defender.

Source: What Credit Ratings Are For