In Defense of the Rating Agencies — II

It is easy to take pot shots at the rating agencies.  Barron’s did it this weekend.  What is hard is coming up with a systematic proposal for reform that will do more good than harm, as I pointed out on my last piece on this topic.   Ordinarily, I like the opinions of Jonathan Laing, but not this time.  In my opinion, Barron’s failed the test of coming up with a systematic solution that recognizes market realities.

From my last article, I will repeat the market 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.

From the Barron’s article:

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody’s officials point out that only 15% or so of the dollar amount of that rated debt — counting all tranches — has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

Having been a mortgage and corporate bond manager back then, I’m not sure I agree.  The ABS, CMBS and whole loan RMBS markets are about the same size as the corporate bond markets.  The degree of stress on the system was higher back in 2002.  To give one bit of proof, look at the VIX, which is highly correlated with corporate credit spreads.   Why was the VIX in the 40s then, and around 19 now?  What’s worse, the banks were in good shape back then, and there are more questions about the banks now.  Most of the current problems exist in exotic parts of the bond market; average retail investors don’t have much exposure to the problems there, but only less-experienced institutional investors.

The Barron’s article suggests five areas for reform:

1. The SEC must encourage more competition by approving more rating agencies.  Rating fees would drop and diversity of opinion would lead to more accurate and timely ratings.

I’m all in favor of more rating agencies.  I don’t think rating fees would drop, though.  Remember, ratings are needed for regulatory purposes.  Will Basel II, and NAIC and other regulators sign off on new regulators?  I think that process will be slow.  Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.

Regarding John Coffee, Jr. in the article:

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron’s and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they’ve rated. Regulators and investors would thus have an effective means of assessing the raters’ rigor.

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

And after that,

2. All rating agencies should be required to disclose default rates on all classes of securities that they’ve rated.  Agencies with bad results should have their SEC approvals yanked temporarily.

Disclosing default rates is already done, and sophisticated investors know these facts; this is a non-issue.  Yanking the registration is killing a fly with a sledgehammer.  It would hurt the regulators more than anyone else.  Further, what does he mean by “miscreant” or “notably wrong?”  The rating agencies are like the market.  The market as a whole gets it wrong every now and then.  Think of tech stocks in early 2000, or housing stocks in early 2006.  To insist on perfection of rating agencies is to say that there will be no rating agencies.

From the article:  One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

“It’s tremendously liberating to just work for investors and not worry about angering the issuer community,” partner Sean Egan tells Barron’s. “Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we’ve led the industry on upward credit revisions of worthy recipients.”

I like Egan-Jones, so it is with pleasure that I mention that they have achieved NRSRO [nationally recognized statistical rating organization] status.  That said, their model that I am most fmailiar with only applies to corporate credit.  Could they have prevented the difficulties in structured credit that are the main problem now?

3. Agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.

If this were realistic, it would have happened already.  The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.  They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

4. Agencies no longer should have exclusive access to nonpublic information, to even out the playing field.

Sounds good, but the regulators want the rating agencies to have the nonpublic information.  They don’t want a level paying field.  As regulators, if they are ceding their territory to the rating agencies, then they want he rating agencies to be able to demand what they could demand.  Regulators by nature have access to nonpublic information.

5. Agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.

Were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?  No.  Did the rating agencies get it wrong?  Yes.  History would have said that GICs almost never default.  As I have stated before, a market must fail before it matures.  After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

Look, the regulators can bar asset classes.  Let them do that.  The rating agencies offer opinions.  If the regulators don’t trust the ratings, let them bar those assets from investment.  The ratings agencies aren’t regulators, and they should not be put into that role, because they are profit-seeking companies. Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.  But if the regulators bar assets, expect the banks to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiency

Look, sophisticated investors don’t rely on the rating agencies.  They employ analysts that do independent due diligence.  Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.  My proof?  Look how little exposure the insurance industry had to subprime mortgages.  Teensy at best.

There will always be differences in loss exposure between structured securities and corporate bonds at equivalent ratings.  Structured securities by their nature will have tiny losses for long periods of time, and then large losses, relative to corporate bonds.  The credit cyclicality is even bigger than that of corporate bonds.

Let’s get one thing straight here.  The rating agencies will make mistakes.  They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won’t pay enough to support the ratings.

Barron’s can argue for change, but unless buyers would be willing to pay for a new system, it is all wishful thinking.  Watch the behavior of the users of credit ratings.  If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

2 Comments

  • Jason Pratt says:

    Look, it’s holiday time so this won’t have the punch it deserves (and I’m a novice at blogging) but this high horse nonsense with calling the rating agencies out is getting old. It’s everything I can do to not write angry letters to the idiots in the media covering this stuff as though it were Watergate all over again. I’ve been doing this for 15 years so (managing fixed income portfolios) and I recognize I’m no sage, but why isn’t anyone talking about the bigger picture? AAA credit at 3M Libor + 25 basis points??? C’mon. Sure, we’ll lever it up 10 times and be happy! Securitization isn’t the problem – investors have not been willing to pull their heads out of the sand and ask if they are getting paid enough for the risk. Relative value investing carries some or a lot of the burden here. Investing for the sake of investing/out of fear that it may not all go wrong makes people weak. But it’s simply too easy to Monday morning QB here.
    Everyone involved at the institutional level absolutely understands that the data backing the ratings on these vehicles is limited. That’s why they were participating. By the way, a prolonged low interest rate environment with little or no credit/default risk since 2002 doesn’t hurt either. How many “traders” have been putting capital at risk (read, waiving it in) since then thinking they were brilliant? What part of sub didn’t you understand? “No brainer trades?” Cheap leverage too? Ah! But to blame the rating agencies? Look, I understand the acedemics plugging competition but Fitch tried to enter the dualopoly and all they could muster was a platform which provided ratings for ABS securities that the other guys wouldn’t rate quite as high. Now it’s a reaction game of who can downgrade harder and faster. In the mean time, Moody’s just fired a bunch of their talent at a time where they need all hands on deck. So, I’ll just say that everyone is involved here at some level – and the market will figure out a way to digest all of this just like it has every other time the sun was compromised temporarily in the past. Risk premiums will rise, investors rather than traders will carry the day and we can reset the table in about a year. Happy Holidays…

  • PaulinKansasCity says:

    Great post David and interesting comments Jason. It appears to me that credit risk will be repriced and the cost of a lot of loans/bonds/etc. will have to increase to the borrower. Once that happens we may see liquidity return and the end of the “sell anything with ABS exposure” trade. See FMD for my 2007 lesson in personal humility of not respecting the psychology of the market enough; yikes!