Despite Their Faults, Ratings Agencies Are Better Than the Alternatives

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be good, and for the conflicts of interest that they face. Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don’t hold much water, because there is no other way to do it. Let those who criticize put forth real alternatives that show systematic thinking. So far, I haven’t seen one.

Here are the 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 and 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.

For my first point, the fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already. The ratings agencies aren’t perfect, and good buy-side shops use them, but don’t rely on them.

Second, the regulators need simple ways in a complex environment to account for credit risk, so that capital positions can be properly sized. They either need rating agencies, or have to be one. No way around it.

Third, financial institutions will buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).

Fourth, financial institutions and regulators have to be “big boys.” If you were stupid enough to rely on the rating without further analysis, well, that was your fault. If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards. Their opinions are just that, opinions. Smart institutional investors often ignore the rating, and read the commentary. The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

Last, ratings agency opinions are long-term by nature, rating over a full credit cycle. During panics people complain that they should be more short-term. Hindsight is 20/20. Given the multiple uses of credit ratings, having a one-time horizon is best, whether short- or long-term. Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond managers I knew wanted stability.

Now there are alternatives. The regulators can ban asset classes until they are seasoned. This could be smart, but there will be complaints. I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955. In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet) will write the next one. Regulators are slow, and they genuinely don’t understand investments.

Another alternative would be to allow for more rating agencies. I’m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not. For other purposes, though, the more raters, the better.

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term. Until then, the current system will persist, because there is no other realistic way to get business done. There are conflicts of interest, but those are unavoidable in multiparty arrangements. The intelligent investor has to be aware of them, and compensate for the inherent bias.

Comments

[Cate Long:]

Good article... thanks for your comments...

It’s a complex issue… this NRSRO issue… but we have created remedies for far more difficult problems… here are some of the proposed regulatory solutions…

Allow the SEC inspection to be completed - hold additional action (CC)

Adopt “equivalent disclosure” for issuer communication with NRSROs (JC) (CK) (CL)

Confer additional regulatory authority to the SEC (SS)

Increase the SEC’s NRSRO oversight budget (AL)

Delink analyst compensation from business development (AL)

Issuer public disclosure of NRSRO fees and consulting (AL) (CK)

Improve transparency of rating triggers in structured finance (AL)

NRSROs should be held liable for malfeasance (AL)

Give issuer audit committees oversight of the NRSRO relantionships (AL)

SEC to monitor the accuracy of ratings methodologies (AL)

Create “cooling off” period for NRSRO analysts (AL)

Grant the SEC authority to revoke NRSRO status (AL) (JC)

Ban the “issuer pay” model of NRSROs

Altering the methods of NRSRO compensation (CK)

Institute rotations among NRSROs for issuers (CK)

Standardize the reporting and meaning of rating symbols by asset class (JC)

Improve the transparency of underlying debt products (CK)

Require complex products to season prior to rating by NRSRO (CK) (JM)

Separate the advising and rating functions of NRSROs (EM)

Make the ratings industry non-profit

Remove the government sanctioned status as NRSROs

Institutional investor sponsored rating agency (AP)

Except for the first solution, which would be to allow the Commission to complete its examinations, the other proposals are all potentially interesting in their effects on the ratings industry… stay tuned…

(AL) = Former SEC Chairman Arthur Levitt
(AP) = Alex Pollock, American Enterprise Institute
(CC) = SEC Chairman Chris Cox
(CK) = House Capital Markets Subcommittee Chairman Kanjorski
(CL) = Cate Long
(EM) = Eric Mindich
(JC) = Professor John Coffee
(JM) = Professor Joseph Mason
(SS) = Senate Banking Committee Ranking Member Shelby

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2007 Dec 05 09:36 AM