The Wall Street Journal is kidding itself if it really believes the problems with the rating agencies can be fixed if only regulators would “stop enforcing [the] oligopoly” held by Moody’s (MCO), Standard & Poor’s (MHP), and Fitch.
No. Even if the credit-rating industry were as fragmented as the used-car business is, agencies would still churn out ratings that, as we’ve seen in the work they did on RMBS CDOs, are inherently unreliable and insufficient as a basis for investment decisions.
Unfortunately, a big part of the fixed income market is set up on the assumption that the agencies are omniscient, and that a debt instrument’s rating is the vital piece of information a fixed-income manager need take account of in deciding whether to invest. The Journal points out that entities ranging from the Vermont retirement system to the Federal Reserve operate under rules (or promulgate them) that mandate that only securities of a certain minimum rating (BBB-, say, or triple-A) are eligible for purchase or as collateral.
That’s crazy, for two reasons. First, it restricts what many fixed-income managers can own, potentially inhibiting returns. And, second, when a security does get downgraded below the mandated level (which happens all the time) managers are forced to sell en masse, causing unneeded volatility and portfolio losses.
Remind me again of the good that does? Public pension funds aren’t required to only buy stocks uniformly rated “Buy” by sell-side analysts, right? Why, then, should fixed-income investors be forced to only hold debt instruments rated “investment grade” by so-called “Nationally Recognized Statistical Rating Organizations”? Instead, let the fixed-income managers do their own analytical work rather than rely on NRSROs, and figure out which securities offer acceptable risk vs. reward, and which ones don’t.
The rating-agency model is broken beyond repair! One of the lessons of the subprime mess, I believe, is that the rating agencies do a whole lot more harm than good. One could even make the argument that the crisis wouldn’t have happened (and surely wouldn’t have been so severe) if there were no agencies standing by to bless paper that turned out to be dubious. If fixed-income managers had been allowed to think for themselves, rather than be forced to lean on the ratings crutch a whole lot of grief, not to mention hundreds of billions in losses, might have been avoided. Let’s kill the NRSRO Charter for good!
Tom Brown is head of BankStocks.com.