kingaj12

Judge's Message to Rating Agencies: Free Speech Not Freedom to Defraud

Very good article and comments, especially Chap08 and MikeOz. Thank you.

Reform of ratings agencies is the main piece of business needed to restore financial health and to allow the central bankers to draw down government issued liquidity. An effective reform will probably require changing the notion of a "rating".

Transparency is the key issue. A ratings service that enables investors to run their own internal models against the underlying assets would go a long way to restoring confidence in asset-backed paper. The technology to do this is all based on Monte Carlo simulation of cash flows from an underlying factor model. As I understand it, these models and their assumptions are part of the material reviewed by a CRA to justify the ratings application.

How to make this transparent to investors? Well, the models and assumption are captured in computer programs that are run against a database of assets, the results of which are part of the submission to the CRA. Computer programs have interfaces that enable users to change their input assumptions (for example: HPA, interest rate trends, etc). If these computer programs are required to have standardized interfaces, then investors could substitute their own models for those reviewed by the CRA - without needing access to the details of each and every asset in the portfolio.

Extending this thought a bit further: CRAs in effect rate the qualities of a computer model that is seeded with assumptions and is run against a database of privileged information. There are many models out there in the financial world. Some models perform better than others in certain environments. If the interfaces are standardized, then investors could subscribe to multiple model providers. Ratings services could track and rate "model" performance!

So how could we get started on this? I think the key requirements are 1) standardization of the inputs of the cash flow generation modules, and 2) the right of any investor to substitute their own model for those examined by the CRA.

Examining the Credit Agencies: The More They Compete, the Higher Their Ratings

Very important issue -- but it is probably a tendency that can be predicted by investors and regulators.

The more serious issue is when Ratings Agency policies contribute to procyclic tendencies in the ABS market. See Ashcraft and Schuermann : papers.ssrn.com/sol3/p...