Eliminating the Rating Agencies, Part 3

There’s one thing that is a little odd about me: occasionally as I am waking in the morning, something that I have been thinking about comes crashing in on me, and I get a moment of clarity where everything seems obvious for a complex question.

So to begin, I would like to say that I was utterly wrong in part 1 and part 2 of this series.  It won’t work.  Here’s why:

When is it safest to buy high yield bonds — when spreads are tight, or when spreads are wide?  Of course, when spreads are wide.  When spreads are tight, it is risky to buy corporates.  But my method for allocating capital would do the reverse: it would force a lot of capital to be allocated when spreads are high, and little when spreads are low.  That’s the wrong way to do it.

Second, most bond defaults occur because the borrower chokes on an interest payment, not a principal payment.  If you can make the interest payments, under normal circumstances, you can refinance the principal.  That indicates that the risk of a bond will grow less than linearly with maturity.  It may even be flat.

The upshot of this, is that you would want to assign capital counter-cyclically if you could, but no one would go for that, it doesn’t fit human nature.  So maybe a compromise works where there is a fixed amount of capital assigned across the cycle, and not varying by maturity.  So how do you make adjustments for variable riskiness?

For corporate bonds that have a public stock trading, a contingent claims model can yield good results.  Egan-Jones does that, though many of the major raters have similar models, that they watch as a check on their fundamental reasoning.

But many bonds have no publicly traded equity to give them estimates of value and volatility.  Whether private corporates or securitized debts, there is no way to accurately estimate risks, unless you have a cash flow database of the underlying properties/assets, and aside from CMBS, that would be hard to get.

That brings us back to the rating agencies.  Much as they failed on rating novel types of debt that the regulators should not have allowed regulated entities to invest in, the rating agencies did a good job in rating seasoned corporate bonds, both private and public, incorporating private data to sharpen their estimates of creditworthiness.

I know that Dodd-Frank has required Federal Regulations to eliminate the use of credit ratings.  What have they substituted? Management judgement, simplistic statistical tests, nothing, and the ability to use quantitative rating schemes.  My view is this: there will be a series of scandals out of this, and there will be a return to the rating agencies, where human judgment takes in the factors that can’t be crunched into an equation.

Thus I return to my opinions expressed in: In Defense of the Rating Agencies – V (summary, and hopefully final). You can’t live with them, but you can’t live without them.

2 Comments

  • microcap says:

    Totally Off Topic David– As I’m sure you saw, the challenge to Maryland’s redistricting plan lost 63-37 or so…

    Every single media outlet I saw urged a vote against the plan, but the Democratic sample ballot urged a vote for it [duh], and in this bluest of blue states, that’s all it takes.

    I actually think that with some money and organization, it could have been defeated. But with the other ballot questions sucking all the air out of the voting booth, I don’t think voters had a clue what it was about.

    On the other hand, it doesn’t say much for the electorate. As a conservative, I tend to think we get the government we deserve..

  • Helical_Investor says:

    David,

    As one involved with pharmaceutical development, I thought the idea proposed by Dan Ariely and likely others to have an FDA like approval mechanism for financial products worthy of consideration.

    To extend that, ratings agencies can be considered as analogous to the quality control function of drug approvals. As such, it is the methods they use to provide ratings that are key to the quality of the rating. If I was to alter how these agencies operate, it would be to have them register their methods with a government agency, as well as the reasoning behind them. Oversight would then mostly entail ensuring the rating methods were applied appropriately and consistently. This should reduce some of the conflicts of interest that exist within the ratings agencies. New or varied financial products seeking a rating would have to wait until a method for providing such a rating was approved.