The Aleph Blog » Blog Archive » In Defense of the Rating Agencies — III

In Defense of the Rating Agencies — III

After writing parts one and two of what I thought would not be a series, I have another part to write.  It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.  (That said, small investors are often, but not always, better of with the summary advice that bond rates give.  Institutional investors do more complete due diligence.)  The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.  Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.  Markets are faster than any qualitative analysis process.  But regulators need methods to control the amount of risk that regulated financial entities take.  They can do it in three ways:

  1. Let the companies tell you how much risk they think they are taking.
  2. Let market movements tell you how much risk they are taking.
  3. Let the rating agencies tell you how much risk they are taking.
  4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.  There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.  The fourth option underestimates what it costs to rate credit risk.  The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.  Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.  As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.  As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.  Ratings should not be like stock prices — up-down-down-up.  A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?  Yes. Big ones.  But ratings are opinions, and smart investors regard them as such.  Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.  You could have barred investment in novel asset classes but you didn’t.  The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five 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.

And because of that, I think that solutions to the rating agency problems will fail.






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One Response to In Defense of the Rating Agencies — III

  1. Terry says:

    I believe that ratings agencies can perform a valuable service for investors, especially in assessing highly complex securities derivatives. OTOH, they can be (and seemingly have been) part of deceptive marketing schemes–maybe unwittingly–by dealers to minimize the risk of these derivatives.

    I think the proper solution for such a situation is to make the ratings agency financially liable for the ratings they provide. If an “AAA” derivative turns out to be junk, allowing the rating agency to change its view in a timely manner, the buyers of the security should be compensated by the ratings agencies (& maybe the dealers) for their failure.

    This would have two salutory effects:
    1. There would be fewer errors and oversights in rating agency models.
    2. The ratings agencies would be fairly (and more fully) compensated by the dealers for the value-added of their ratings.

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