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Do We Need Rating Agencies?

 It’s not a matter of debate that the credit rating agencies had a big hand to play in the mortgage industry meltdown. Misjudging risk, allowing dealers to buy higher ratings through additional layers of phantom “credit protection,” and having incentives that aligned closely with securities issuers, the structure and execution at rating agencies is fundamentally flawed. But should they be circumvented altogether in securities issuance?

The securitization market is still weak, prolonging the difficulty in consumer and business lending and stifling growth in the economy. Securitization has a practical place in investing and is primarily intended for risk management. Securitized products allow professional money managers the ability to segment risk layers of the underlying collateral. Long-term mortgages, for example, have significant interest rate volatility risk. Certain segments or tranches of structured mortgage securities (CMOs), alternatively, allow more conservative investors the ability to limit their exposure to interest rate swings by giving up some yield.

The intent of issuing securities with a credit rating is so investors have a standardized tool for measuring risk. The problem was that investors relied too heavily on the underlying credit rating and did not do suitable diligence to fully understand the deals they were buying. This, coupled with the fact that the ratings were fundamentally flawed led to a destructive result. Once the music stopped, we faced a liquidity crisis of unforeseen proportions. Not necessarily because every deal in the market began to go sour – the major cause of the liquidity crisis is that when it was widely discovered that many credit ratings were flawed, investors didn’t know what they held their portfolio and therefore could not properly assign value. Trading froze as did the securitization market.

Can credit ratings therefore be eliminated completely from securitizations? A few unrated deals have been sold recently with more coming. Credit Swisse sold $1 billion in structured mortgages they purchased from AIG and the government of Dubai has begun to issue unrated debt, among others. This is a positive development in the effort to revive securitization, but moving forward without a metric for standardization will greatly constrain market liquidity.

Securitization deals can be complex and understanding the layers of risk and collateral takes thoughtful diligence and analysis. Credit ratings are meant to be a tool (not the only one!) for comparative pricing. It is similar to how the stock market values a company’s P/E ratio. Where one stock is trading on a P/E ratio versus another is a metric for evaluating relative value. As well, the baseline earnings rate is just an estimate derived from analysts evaluating a company’s fundamentals. Similarly, credit ratings for securities are meant to provide a method for comparison. The problem does not lie in the fundamental purpose of a credit rating. The problem is in how those ratings have been assigned historically. As investors, we would be much better served with a viable and durable ratings methodology than without a means of standardization. Without a method of standard comparison, greater liquidity will not and cannot exist. This would be detrimental for investors and credit consumers alike. I’m not suggesting that professional investors should skirt their fiduciary duty of properly analyzing and understanding the risk/reward metrics of the securities they purchase. That is the key to expert investing and another topic altogether. I do, however, believe that a vibrant securitization market is necessary for financial growth and rating agencies play an important role in creating a basis for interpreting deal risk. Their methodology needs to be revamped and their incentives realigned. But there is a market necessity to improve and maintain liquidity, with credit ratings acting as one tool to do so.