In Defense of the Rating Agencies – V (summary, and hopefully final)

I write this because I was invited to be on CNBC on the topic, but I suggested that my opinion would not make for good television.  That said, I have taken my four prior posts on the topic, and assembled them into one comprehensive post.  I do not intend on posting on this again.  With that, here is my post:

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.

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.

Here are my five realities:

  • 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.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.  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.
  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

Ratings are Opinions

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.  Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.  My proof?  Look how little exposure the Life and P&C insurance industries had to subprime mortgages outside of AIG.  Teensy at best.

Please understand that institutions own most of the bonds out there.  We had a saying in a firm that I managed bonds in, “Read the write-up, but ignore the rating.”  The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line.  They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

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.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.  They know that ratings are just opinions, except to the extent that they affect investment policies (”We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument).  Now, sophisticated investors knew that AAA did not always mean AAA.  How did they know this?  Because the various AAA bonds traded at decidedly different interest rates.  The more dodgy the collateral, the higher the yield, even if it had a AAA rating.  My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.  Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.  Early in the 2000s, sophisticated investors got burned, and learned.  That is why few insurers have gotten burned badly in the current crisis.  Few insurers bought any subprime residential securitizations after 2004.  But, unsophisticated investors and regulators trust the ratings and buy.

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.  As I said before, smart institutional investors 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.

How Can Regulators Model Credit Risk?

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 off with the summary advice that bond ratings give.)  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 four 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.

Also, their models that I am most familiar with only apply to publicly-traded corporate credit.  Could they have prevented the difficulties in structured credit that are the main problem now?

What to do with New Classes of Securities?

Financial institutions will want to buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).  But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?  Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.  A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.  Instead, they do some qualitative comparisons to similar but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.  Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.  As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.  Gaussian copula?  Using default rates for loans on balance sheet for those that are sold to third parties?  Ugh.

Some will say that rating agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.  That’s a noble thought, but 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.

But think of something even more pervasive.  For almost 20 years there were almost no losses on non-GSE mortgage debt.  How would you rate the situation?  Before the losses became obvious the ratings were high.  Historical statistics vetted that out.  No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.  In this case both raters and investors have had their heads handed to them.

Now there are alternatives.  The regulators can ban asset classes until they are seasoned.  That would 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.  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 ban asset classes, expect those regulated to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiencies.

Compensation and Conflicts

Some say that rating 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.

Short vs. Long-Term Opinions

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.

Non-solutions

Some say rating agencies no longer should have exclusive access to nonpublic information, to even out the playing field.  That sounds good, but the regulators want the rating agencies to have the nonpublic information.  They don’t want a level playing field.  As regulators, if they are ceding their territory to the rating agencies, then they want the rating agencies to be able to demand what they could demand.  Regulators by nature have access to nonpublic information.

Some ask for greater disclosure of default rates, but that is a non-issue.  They also look to punish rating agencies that make mistakes, by pulling their registration.  Disclosing default rates is already done, and sophisticated investors know this.  Yanking the registration is killing a fly with a sledgehammer.  It would hurt the regulators more than anyone else. 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.  It takes two to make a market, and agencies will often be wrong.

Solutions

As for solutions, I would say the following are useful:

  • Competition.  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.  I don’t think rating fees would drop, though.  Remember, ratings are needed for regulatory purposes.  Will Basel II, NAIC, and other regulators sign off on new credit raters?  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.
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
  • Have regulators bar unseasoned asset classes.

Summary

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.

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.