In Defense of the Ratings Agencies
The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face. Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don’t hold much water, because there is no other way to do it. Let those who criticize put forth real alternatives that show systematic thinking. So far, I haven’t seen one.
Here are the realities:
- There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
- Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves. The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies. The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
- New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
- Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
- Ratings can be short-term, or long-term, but not both. The worst of all worlds is when the ratings agencies shift time horizons.
For my first point, the fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already. The ratings agencies aren’t perfect, and good buy-side shops use them, but don’t rely on them.
Second, the regulators need simple ways in a complex environment to account for credit risk, so that capital positions can be properly sized. They either need rating agencies, or have to be one. No way around it.
Third, financial institutions will buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).
Fourth, financial institutions and regulators have to be “big boys.” If you were stupid enough to rely on the rating without further analysis, well, that was your fault. If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards. Their opinions are just that, opinions. Smart institutional investors often ignore the rating, and read the commentary. The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.
Last, ratings agency opinions are long-term by nature, rating over a full credit cycle. During panics people complain that they should be more short-term. Hindsight is 20/20. Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term. Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.
Now there are alternatives. The regulators can ban asset classes until they are seasoned. Could be smart, but there will be complaints. I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955. In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one. Regulators are slow, and they genuinely don’t understand investments.
Another alternative would be to allow for more rating agencies. I’m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not. For other purposes, though, the more raters, the better.
Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term. Until then, the current system will persist, because there is no other realistic way to get business done. There are conflicts of interest, but those are unavoidable in multiparty arrangements. The intelligent investor has to be aware of them, and compensate for the inherent bias.
December 4th, 20078:00 am at
David
Totally agree with your assessment of the ratng agencies. Maybe I’m mistaken but my impression is most of those calling for change in rating agencies are not dedicated fixed income investors. One area you did not touch on was the stocks and their future earnings power.
At what point do you think they become attractive from a valuation standpoint? Moody’s talks about only having one down year in revenues over the last 20, which is a testament to the consistent growth in debt and their position as toll keeper. But the last few years were well above trendline growth in debt — how long could the hangover last? could international markets offset the US?
2008 could be down (Tony C. said yesterday that debt issuance is actually holding up well so far) but that seems expected by the consensus. Any thoughts on MCO or MHP would be much appreciated.
thanks
Kyle
December 4th, 200710:02 am at
The pseudo-simplicity of the letter grade system used the the agencies seems like an anachronism to me. Wouldn’t it be more sensible to give two numbers, one for probability of default and one for expected discounted cash flow on a given obligation (with fully stated assumptions) or some equivalent? Intuitively, we’d expect less sticky friction and more frequent updates if numerical ratings were used. Using two numbers would also prevent confusions like the one we’ve seen with subordinated tranches of CDOs, where default implies very high loss expectations.
February 18th, 200811:09 pm at
Well, congratulations. You have convinced yourself that the only way is the current way and the con game of Wall St. should continue, indeed, obviously to your way of thinking, the con game _must_ go on.
One by one, the wall st. cons are falling, almost (but not quite) as fast as the cons think up new way to fleece investors.
It’s not the con you know that you should be worried about, it’s the con you don’t yet know. So, the question now is, what new cons does the street have up its sleeve?
To see it, you have ask, now that the jig is up for the glossy varnish con of “ratings” that legitimize bogus value has met the light of day, what is stirring underneath, in the very heart of wall street. For that is where we must look for the next con – where they think we are not looking. Probably deep in the transactional stream itself, far from prying eyes.
Yes to see it, you have to rub your eyes and look again at what is staring you square in the face, so obvious that you cannot see it. Today, that would be the rigged volatility we are seeing in the market. It’s all just another con run by some guy behind a curtain. Focus now, come on, can you see it? Look closer…
February 18th, 200811:45 pm at
I don’t think of ratings as a “con,” and I do think that it would be very difficult to get users to pay for ratings. There’s no concentrated interest. Ratings are needed for regulatory capital purposes, and the regulators don’t have the capability.
So, propose a better system that fits in with the way the fixed income community does business. Most of the institutional investors that I know, knew which ratings not to trust… People who invest only on ratings get what they paid for: trouble.
February 20th, 20082:22 pm at
I’m not sure I follow you. If you have to know the difference between a good rater and a bad rater, who needs any raters at all?
The rating system itself is failing or at the very least is vulnerable. They turned a blind eye and indirectly created one crisis by blessing risky deals, now they’ve woken up and are creating another by jerking the leash.
That makes them a single point of market failure and begs the question, who’s rating the raters? Answer: evidently, no one, and thus the inevitable con.
Investors don’t want to pay for analyst research either, but there are now rules on the books separating them (somewhat) from the sales side.
Of course, whether they wanted to or not, every investor in the market has certainly paid dearly over the past 6 months and is still recovering from the rating agencies mistakes. Altogether we paid a far higher price than the sum total of the market cap of these agencies. We paid alright, but we did not get what we paid for.
Where there are conflicts of interest there must be counterbalancing transparency, disclosure and oversight or we will all pay the price again and again. Trust is not an option. If the market can’t figure it out, then perhaps as a last resort it will take a quasi-govermental agency to ride herd on the raters…