A History of Credit Ratings

Dennis Berman gets it right in today’s WSJ. We have institutionalized the use of credit ratings and mandated their use in regulation to the degree that it has been allowed to replace individual due diligence. It is convenient for individuals, fiduciaries and politicians to pile on the ratings agencies and attribute all sub optimal economic outcomes to the “incompetent” ratings agencies. Everybody has a scapegoat, and the power of the Federal government is bearing down hard on the NRSROs.

Berman makes a good case for knowing the history of ratings before we try and implement a solution.

We should also know what ratings measure. There is a huge gap between what a rating measures and what the general public (and Congress) thinks it measures. There is also a huge problem in using a single obligor ratings system in a multiple obligor security sector.

 We have two choices:

More government involvement (the Al Franken Plan): Otherwise known as the “how is that working out so far” solution…

Or

The  logical conclusion: De-certify the NRSRO designation, remove the references to ratings from the Federal statutes, and let caveat emptor rule.

If you don’t know what the credit “worthiness” of a bond of an asset is, don’t buy it. If you have an investment manager or a fiduciary representing your interests, it is their responsibility to understand underlying credit. This will let the market establish the usefulness of Credit Ratings Agencies and the concerns of ratings shopping without government involvement or any additional regulation.

We have to know the history of ratings, NRSROs and the mis-application of a ratings system architecture to a modern structured finance asset class. The Franken solution will raise the cost of capital and make it less available. The elimination of the NRSROs will let investors be responsible for their own decisions.

The Credit Raters: How We Got HereWall Street Journal, May 25, 2010

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