Time to Regulate the Debt and Equity Rating Industies

This is a continuation of the thoughts expressed in an earlier blog entry of mind from January(In Dire Need of 'Positive Economics').

As continued losses unwind in the mortgage sector, the resultant spillover has affected consumer loan portfolios, credit card portfolios and caused overall damage to the retail consumer psyche. It’s once again imperative that we at least reactively think of what could have helped avoid this credit avalanche – and what can help in the future.

One of the points discussed in my January blog linked above was the role played by credit rating agencies and equity research houses in the whole mess. With this context, it is interesting to analyze a recent Feb. 8 news article related to potential SEC monitoring on credit rating agencies – SEC May Propose New Rules for Credit-Rating.

The rules would increase disclosure about ‘past ratings' to help determine whether rankings successfully predicted the risk of default, SEC Chairman Christopher Cox said at a securities conference in Washington today. The regulations may also address the differences between ratings on structured debt and rankings for corporate and municipal bonds.

Even more interesting, the report states:

Investors could then use the enhanced disclosure to ‘punish chronically poor and unreliable ratings,’ Cox told reporters after his speech. ‘The rules that we may consider would provide information to the markets in a way that facilitates comparisons’, he said.

It’s heartening to see this finally taking shape, though it has been pretty late already – way back during the 1997 South East Asian crisis, there was already intense criticism of the lack of fore-warnings provided by the rating agencies. This is obviously a classic case of conflict of interest, with rating fees being paid by the borrowers and not investors. We probably need a combination of 2 drivers – One, an incentive mechanism that rewards agencies based on past performance & Two, regulatory disclosures like the one mentioned above which would help monitor this industry. One interesting approach:

• Set up an “Investors’ Rating Fund”, with oversight by either a market consortium or by a rating ombudsman. This would be funded by a 0.1 bps charge on any rated debt floated in the market – this can be paid for partly from rating agency fees and partly from borrower money. This would build a significant pool of money, considering that high-grade corporate debt issuance a year in US totals over USD 900 billion per year. This could be used to ‘reward’ best performing rating agencies based on rating performance comparisons as indicated by debt performance within 12 months immediately following lat rating.

The above idea is clearly indicative of the need to flush out a lot of details related to performance comparison models, Rating Fund administration and ownership. Though there would be significant opposition by many market participants, it would help foster safer debt markets in the future and to a certain extent balance inherent conflicts of interest within the industry model.

If rating agencies can be regulated (either by an ombudsman or by a market-driven fund like that mentioned above), why not apply the same to equity rating agencies? Apart from the overall inability of equity rating agencies to predict the sub-prime bust and potential bank stock revaluations, we have had several close-to-irresponsible analyst comments recently, including the controversial ‘potential bankruptcy’ call on E*Trade (ETFC).

There is an urgent need to evolve a regulatory or market driven mechanism to monitor and publish prediction-ability of rating models. Agreed that credit ratings and equity ratings differ widely in their inherent ability to predict the marker, however, it should be possible to evolve a model which would evaluate equity rating effectiveness based on a quarterly performance indicator, excluding effect of (unpredictable) significant political and natural events which might impact stock performance. There could even be a similar fund sent up for Equity Investor protection, though the very act of monitoring and publishing rating effectiveness indicators would have a salutary effect on the overall market.

Again, I am not an advocate of central regulatory policing of free-market agencies; however, it's high time that industry forces joined hands with regulators, as needed, to imbue a sense of discipline within the credit rating and equity rating industries.