Barron's Critique of Rating Agencies Fails the Test

It is easy to take pot shots at the rating agencies. Barron’s did it this weekend. What is hard is coming up with a systematic proposal for reform that will do more good than harm, as I pointed out on my last piece on this topic. Ordinarily, I like the opinions of Jonathan Laing, but not this time. In my opinion, Barron’s failed the test of coming up with a systematic solution that recognizes market realities.

From my last article, I will repeat the market 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.

From the Barron’s article:

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody’s (MCO) officials point out that only 15% or so of the dollar amount of that rated debt — counting all tranches — has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

Having been a mortgage and corporate bond manager back then, I’m not sure I agree. The ABS, CMBS and whole loan RMBS markets are about the same size as the corporate bond markets. The degree of stress on the system was higher back in 2002. To give one bit of proof, look at the VIX, which is highly correlated with corporate credit spreads. Why was the VIX in the 40s then, and around 19 now? What’s worse, the banks were in good shape back then, and there are more questions about the banks now. Most of the current problems exist in exotic parts of the bond market; average retail investors don’t have much exposure to the problems there, but only less-experienced institutional investors.

The Barron’s article suggests five areas for reform:

1. The SEC must encourage more competition by approving more rating agencies. Rating fees would drop and diversity of opinion would lead to more accurate and timely ratings.

I’m all in favor of more rating agencies. I don’t think rating fees would drop, though. Remember, ratings are needed for regulatory purposes. Will Basel II, and NAIC and other regulators sign off on new regulators? I think that process will be slow. Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.

Regarding John Coffee, Jr. in the article:

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron’s and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they’ve rated. Regulators and investors would thus have an effective means of assessing the raters’ rigor.

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

And after that,

2. All rating agencies should be required to disclose default rates on all classes of securities that they’ve rated. Agencies with bad results should have their SEC approvals yanked temporarily.

Disclosing default rates is already done, and sophisticated investors know these facts; this is a non-issue. Yanking the registration is killing a fly with a sledgehammer. It would hurt the regulators more than anyone else. Further, what does he mean by “miscreant” or “notably wrong?” The rating agencies are like the market. The market as a whole gets it wrong every now and then. Think of tech stocks in early 2000, or housing stocks in early 2006. To insist on perfection of rating agencies is to say that there will be no rating agencies.

From the article: One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

“It’s tremendously liberating to just work for investors and not worry about angering the issuer community,” partner Sean Egan tells Barron’s. “Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we’ve led the industry on upward credit revisions of worthy recipients.”

I like Egan-Jones, so it is with pleasure that I mention that they have achieved NRSRO [nationally recognized statistical rating organization] status. That said, their model that I am most familiar with only applies to corporate credit. Could they have prevented the difficulties in structured credit that are the main problem now?

3. Agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.

If this were realistic, it would have happened already. The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit. They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know which they will choose.

4. Agencies no longer should have exclusive access to nonpublic information, to even out the playing field.

Sounds good, but the regulators want the rating agencies to have the nonpublic information. They don’t want a level paying field. As regulators, if they are ceding their territory to the rating agencies, then they want he rating agencies to be able to demand what they could demand. Regulators by nature have access to nonpublic information.

5. Agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.

Were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992? No. Did the rating agencies get it wrong? Yes. History would have said that GICs almost never default. As I have stated before, a market must fail before it matures. After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

Look, the regulators can bar asset classes. Let them do that. The rating agencies offer opinions. If the regulators don’t trust the ratings, let them bar those assets from investment. The ratings agencies aren’t regulators, and they should not be put into that role, because they are profit-seeking companies. Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies. But if the regulators bar assets, expect the banks to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiency

Look, sophisticated investors don’t rely on the rating agencies. They employ analysts that do independent due diligence. Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime. My proof? Look how little exposure the insurance industry had to subprime mortgages. Teensy at best.

There will always be differences in loss exposure between structured securities and corporate bonds at equivalent ratings. Structured securities by their nature will have tiny losses for long periods of time, and then large losses, relative to corporate bonds. The credit cyclicality is even bigger than that of corporate bonds.

Let’s get one thing straight here. The rating agencies will make mistakes. They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won’t pay enough to support the ratings.

Barron’s can argue for change, but unless buyers would be willing to pay for a new system, it is all wishful thinking. Watch the behavior of the users of credit ratings. If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

Comments

[Johnny Bitc...:]

Your comment: If this were realistic, it would have happened already. The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit. They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know which they will choose.

Couple of things:

You really make no reasonable arguments for your perspective here. Most monopolists/oligopolis... want the status quo more than anything else. The idea that they'd just be delighted to have to compete for customer revenues based on the quality of information provided is just silly. They want the status quo.

As far as choosing between avoiding conflicts of interest or death, you are missing the point. The point is that they shouldn't be given the choice of conflicts of interest:

The choice is between providing a service that customers willingly choose to pay for (without conflicts of interest) and death.

Got buddies with comfortable jobs at the ratings agencies ?

Johnny B.

2007 Dec 25 03:36 PM

[Johnny Bitc...:]

You wrote: Look, sophisticated investors don’t rely on the rating agencies. They employ analysts that do independent due diligence. Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime. My proof? Look how little exposure the insurance industry had to subprime mortgages. Teensy at best.

Couple of things:

Regulators prime purpose is not to protect sophisticated investors, as you seem to be implying - one would hope that is obvious.

I am not sure you have provided "proof" that the insurance industry avoided subprime because it didn't trust the ratings. My guess is that it's more likely related to mandate of the investment portfolio and/or restrictions. Regardless, you've provided nothing close to the "proof" which you claim.

As far as the users of ratings, rubes or otherwise, I am sure it is a wider group than you think that uses them. Unfortunately many use them as cover for their own lack of due diligence and understanding.

And just to re-emphasize the purpose of regulation, it is not to protect sophisticated investors, but rather the rubes which you seek to insult.

You seem to have an attitude that rubes should be taken advantage of because they are rubes, and sophisticated investors know the ratings agencies bullshit is bullshit.................

Given this, it would seem to follow that there really is no purpose for the rating agencies....sophistica... investors ignore and don't need them, and rubes deserve to be taken advantage of.

Do I have you figured out ?

Johnny B.

2007 Dec 25 03:48 PM

[Donald Johnson:]

Bond markets have been and will be used by institutional markets because individuals have neither the expertise nor resources needed to do due diligence, and the credit rating agencies have too many conflicts of interest to be trusted even if their reports were easily accessible by individual investors. Further, the bond markets are relatively illiquid and over-hyped by Wall Street and should be avoided by individual investors until they offer more transparency and liquidity.

2007 Dec 26 12:20 AM

[newellm:]

The entire foundation of debt is currently based on FICO scores, incomes, corporate financial statements, appraisals, etc. NONE of these things take into account FUTURE macro-economic changes, all are based on the PAST.

As long as any large fundamental issue is mis-understood by the general society, all the ratings will turn out to be crap.

As long as entire industries experience "black swan", "we never imaged" moments, the ratings will always be great until they are simply crap.

2007 Dec 26 11:23 AM

[Johnny Bitc...:]

Ratings agencies are not the general society, but rather are expected to have skill and competence in analyzing the safety (or lack thereof) of securities.

Some securities, due to complexity or lack of reliable historical data, should simply not be rated by these agencies.

Instead they use optimistic or irrelevant historical data to rubber stamp the securities that their paying customers want to sell. It's not too hard to see that the conflict of interest is absurd.

jbd.

2007 Dec 26 06:29 PM

[20-20 Hind ...:]

What exactly is the "service" the ratings agencies provide and get paid for?

We can't expect individual investors and investing institutions to crawl through several hundred pages of disclosures. The ratings agencies get paid very well for performing this task.

Just focusing on one sin, please explain how anyone can fairly rate any debt that is low or "no-doc".

Relying on historical default rate to rate debt is the last vestige of the lazy and simple minded. What happened to the classical "3-C's" of lending? If there is no documentation, "character" and "cash flow" are missing.

Tranching the bundled securities does not reduce the overall risk. Yet the ratings agencies rank the majority of the tranches investment grade.

Another layer of SOX-like rules won't even lock the barn door. I hate to admit it, we need a few dozen attorneys to skin the hide off these rating agencies. Perhaps, just perhaps, they will use *judgement* when the next hot security lands on their front doors.

2007 Dec 27 05:56 PM