Taking the Road More Travelled

Shelby gives them a solution and they ignore it and report back in a year. So the Congressional solution to a regulatory failure is to let the same regulators study the problem and report back in a year if any changes need to be made.

Frank and Kanjorski had it right in the House version. De-recognize the NRSRO designation, strip the reference to ratings from the Federal Register, and let investors (and their advisors) bear the burden of due diligence.  If ratings are worthless without an NRSRO-mandated use, the ratings agencies will fold.

The capital markets are complicated and diverse. Millions of transactions a day defy static and specific rules. Let’s have less rules, more surveillance and prosecution. Enter the capital markets at your OWN RISK. If you expect the upside of an investment, you have to bear the downside. Ratings can’t be used as a substitute for personal due diligence.

House-Senate Talks Drop New Credit-Rating Rules – The New York Times, June 15, 2010

Rating Amendments Still Ongoing

If the SEC doesn’t like Moody’s methodology, why do we allow the ratings to dictate credit quality in investment policy, regulatory enforcement and public policy?

The ratings don’t measure credit quality, they measure “distance” to first dollar loss. The House bill tried to eliminate all reference to credit ratings from the federal register. The Senate version is not as comprehensive, but the amendment process is not over.

Moody’s Declines 8.1% After Disclosing ‘Wells Notice’ From SEC – Bloomberg, May 10, 2010

There Are Many Ways to Be Precise

There appears to be a great deal of consensus that the rating system, as it is applied to single obligor securities, is fine. Problems arise, however, when the same scale is used for multi-obligor securities.

Some feel that we need to go to a numerical scale when evaluating a multi-obligor bond. Others present a letter-grading scheme that is more precise than the conventions now being used. Whether we choose letters or some numerical convention it really doesn’t matter.

Whether a high risk bond is rated “60” or a “Ca”, a “CC” or a “CCC”, is irrelevant. We simply need to ensure everyone understands the risk and can decide whether the profile is appropriate for their objectives.

What is far more critical than the scoring convention is to ensure credit rating agency analysts have the information, the time, the tools, and the models he or she needs to precisely ascertain risk.

So if a new rating system is devised, it needs a convention that can be attached at the individual obligor level. Each mortgage in a bundle, for example, needs to be scored on its own merits. These scores can then be aggregated and an accurate risk assessment made.

Once a bond is bundled, it’s too late.

A Better Ratings System Is Just A Start

Creating a new rating system for multiple obligor securities is a good idea. There is broad agreement that structured products like bundled mortgage-backed securities need to be rated on a scale that provides for a greater degree of precision to more accurately evaluate their risk. The A-B-C system that has been used for generations to rate single obligor securities is simply too coarse a measure.

 But it is incorrect to concentrate the argument solely on the need for a more robust rating scale.

There is plenty of anecdotal evidence — and possibly now even testimony — that bears out that regardless of how makeshift the measures being applied may have been, they were inappropriately applied. Even fraudulently applied.

Structured securities that analysts at ratings firms like Moody’s, S&P and Fitch either knew to be of questionable value or had no ability to accurately evaluate were getting rated A1, A+, AA and higher. This is the problem. Changing the rating system, although necessary, won’t protect investors from its intentional or unintentional misapplication.

Were the inflated ratings due to conflicts of interest? Lack of oversight from a depleted regulatory community? Or the simple inability of analysts to keep up with the volume of business? These are the questions that need answers.