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.