Don't Try to Fix the Rating-Agency Model: Get Rid of It

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.

Comments

[EtoileBrilliant]

One small problem, Basle II. After 5 years of negotiating and another 5 years of implentation, you can't get away from the fact that ratings underpin the whole concept of bank regulatory capital. Bring on Basle III (2018?)

[tvb]

The problem with the agencies is not that there are too few competitors -- quite the opposite. For corporate ratings, the agencies track record is good, overall, because there are only two main players (Moody's and S&P) and most bonds require ratings from both. For that reason, the agencies can rate objectively without the threat of losing business. In structured finance, the existence of three main agencies (Moody's, S&P, and Fitch), with ony two ratings generally needed, meant that one agency was tough on the ratings, the issuer would just go elsewhere for their ratings. This "rating shopping" is what led to inflated ratings for many structured finance credits. With more agencies, the "rating shopping" and inflated ratings would likely worsen. Competition reduces quality in industries where objectivity should prevail over a clients immediate desire (a high rating).

[Muzovir]

"For corporate ratings, the agencies [sic] track record is good, overall"

I would love to trade with you, tvb, often, and in large volumes. Let's try to go down memory lane (of recent years only) - the Asian Crisis of 1997 (with all the corporates there), or closer to home - Xerox, WorldCom, Enron, Ford & GM - which one of those was well tracked by the NRSROs?

[phdinsuntanning]

just for get them and focus in the important thing:

US March 31
March 31 2008 Fiscal Year 2007: Capital/Assets


1 US Bank Wachovia 10,2%
2 US Bank Bank of America 8,6%
3 US Bank Wells Fargo 8,3%
4 US Bank JP Morgan 7,9%
5 EU Bank Santander 6,3%
6 EU Bank HSBC 5,8%
7 EU Bank BBVA 5,6%
8 US Bank Citigroup 5,2%
9 EU Bank Royal B Scotland 4,8%
10 US Broker Goldman Sachs 4,5%
11 EU Broker Credit Suisse 4,4%
12 EU Bank BNP Paribas 3,5%
13 US Broker Lehman 3,3%
14 US Broker Merril Lynch 3,1%
15 US Broker Bear Stearns 3,0%
16 US Broker Morgan Stanley 3,0%
17 EU Bank Barclays 2,6%
18 EU Broker Commerzbank 2,6%
19 EU Broker UBS 1,9%

[tvb]

You're very ill-informed Mirsovir, so happy to trade with you "often and in volume". The ratings for corporate ratings have been good, OVERALL, although there are always going to be some exceptions and bad calls. Enron, Worldcom, etc. were misjudged by not only the rating agencies, but most everyone else on Wall Street, including the analysts on the buy and sell-side. The bad calls from the Asian crisis were for sovereign, not corporate ratings. Look at the corporate default statistics by rating category and you will find that, OVERALL, they are VERY accurate and predictive. That is simply a statistical fact.

[MD]

And replace them with what? You can't get rid of the existing system without a better replacement. The last thing you want is each individual investment house trying to rate debt on their own. Without the NRSROs, how does yield get determined? You don't want 20 investment banks rating debt - this is a formula for "rating shopping" and will lead to worse results. Look, these guys made some bad calls, no question. The instruments they were rating were fairly new and complex. You learn from mistakes, make adjustments, and move on. That's the solution.

Steve
magicdiligence.com

[MD]

And replace them with what? You can't get rid of the existing system without a better replacement. The last thing you want is each individual investment house trying to rate debt on their own. Without the NRSROs, how does yield get determined? You don't want 20 investment banks rating debt - this is a formula for "rating shopping" and will lead to worse results. Look, these guys made some bad calls, no question. The instruments they were rating were fairly new and complex. You learn from mistakes, make adjustments, and move on. That's the solution.

Steve
magicdiligence.com

[W.E. Coyote S.G.]

So Tom, let me get this straight. When you disagree with someone criticizing one of your investments (MBI or ABK), as with the case in your posting railing against Warren Buffett, you use one type of logic:

"Point 1: An insurer’s credit rating should be based on the ratings agency’s judgment of its ability to pay claims. Period. The insurer’s stock price, which can be—and has been, often—bumped around by the whims and passions of the market, has nothing to do with it."
- Tom Brown: May 7, 2008


Yet when the rating agencies agree with Buffett, you say:

"The rating-agency model is broken beyond repair!"
- Tom Brown: June 26, 2008

So which is it?

Your arguments remind me of an interview in the FT where Robert Merton tried to rationalize the LTCM fallout as the result of irrational markets and not the failure of the fund's models.

It is interesting to see how far people will go to not have to admit they were wrong.