Start a Rating Agency, Why Don’t You?
Many finger the ratings agencies for a portion of our current problems, and to be sure, they deserve blame. Many of the recommendations call for eliminating the opinions of the ratings agencies from anything that might determine regulatory capital levels. Let the regulators do it themselves, instead.
That’s a nice dream, or, for those in the insurance industry, a nightmare. The insurance industry survived such an institution, the NAIC Securities Valuation Office, and lived to tell of it.
It is said that if you can’t get work as a credit analyst, go work for the rating agencies. They always need people, because the competent would never stay around due to low pay. Well, the NAIC SVO was if anything worse, and for those of us that interacted with it, we had no sorrow when they moved to the rating agencies. In terms of speed, much better. Even the opinions were more intelligent.
I’m not saying that the rating agencies didn’t make errors; of course they did. Most often it was over asset sub-classes that were new, and had never been through a bust cycle. They would always be too optimistic.
Now when the regulators blame the rating agencies, it is all too convenient. Why not blame the regulators? They can ban any asset class that they hate; in the past, regulators typically banned assets until they were seasoned enough for institutions with trust obligations to buy them.
The rating agencies typically did well rating asset sub-classes that had experienced significant failure at some point in the past. Ranking corporate bonds and corporate loans against each other — no one should argue that they did a bad job rating them in aggregate. Structured products are another matter, and the rating agencies, through their conflicts of interest, got sucked into the boom-bust cycle.
With that, I put it back to the regulators. You don’t want to depend on the rating agencies? Fine, create your own rating agency, and staff it with top talent. Wait, you can’t afford that? Okay, staff it with people that could work for the rating agenices. You can’t afford that either? Ugh. Well, at least, limit your goals, and tell those you regulate that they can’t invest in complex products that you can’t understand and rate. Wait, you’re getting pushback from politicians telling you that you’re killing those that you regulate? Tell them to jump of a cliff. Wait, they are suggesting the same to you?
Now, many argue that a rating agency run by the regulators would be insulated from influence from Wall Street. It’s not that easy. If the ratings have a dominant effect on whether securitizations get done or not, you can bet that Wall Street will call to solicit their opinions in advance of issuance. Once the ground rules are set, Wall Street will lobby the analysts, showing much the same approach that they did with the private rating agencies, in order to get them to change/loosen their opinions. (I experienced this with the NAIC SVO; they would usually fall in line with the private rating agencies, because it made their life easy.)
I am not a defender of the private rating agencies as much as a explainer that it is difficult to avoid the problems that they face. The problems exist in any situation where a third party tries to analyze a wide number of credit relationships.
This is why I am skeptical in the long run of any effort to replace the rating agencies by the regulators. As a challenge, I say “Go ahead, try it. Past efforts like this have failed, and you will as well.” I say this not as a lover of the private rating agencies, because they have done me wrong as well. The problems of the rating agencies are endemic to any third party evaluation of credit. Better to be wise to their biases as an institutional investor, and avoid their weaknesses, than to be naively credulous, and complain that you got cheated because a rating was too high.
January 7th, 20097:40 am at
I saw an editorial (in the WSJ I think) that had an interesting proposal - use the yield spread over treasuries to determine fixed income risk, not agency ratings. Although the market will occassionally overreact, it generally gets it right on average.
Rating agencies can still exist to set benchmarks and give investors the big picture view about risk, but the market would set the final price.
January 7th, 200912:09 pm at
The difficulty is the same as SFAS 157 — for many of the bonds determining the price is tough. Most bonds do not trade often, so do you price them by a formula? Whose formula? Perhaps one devised by the regulators or a third party, like Bloomberg?
Even then, some small amount of the bonds no formula can price well…
I’d be willing to try it as an idea, but there would be significant bugs to work through.
January 7th, 20091:50 pm at
Great points. Do you think that another problem with our current system is that there are so FEW recognized rating agencies given what they’re tasked to do? It’s my impression that Moody’s and S&P are really the only games in town (Fitch as a distant 3rd) and thus the disruption to the market when their models get it wrong is so much more amplified……
January 7th, 20092:21 pm at
The more rating agencies the better, though the market could only fund so many.
My view is that the rating agencies can’t handle new asset classes, and so regulated institutions should not be allowed to hold those assets until the asset class has gone through market failure once.
The rating agencies do pretty well once they have a full cycle of loss statistics to work with.