Goodbye, Ratings?
On CNBC two weeks ago, Congressman Barney Frank proposed to do away with bond ratings. At the time, it seemed like posturing.
Then it was announced that there will be a hearing for a Banking Sub-committee on September 30th. Among the listed discussion points are a full section on the removal of ratings from statutory references, as well as a draft bill.
The unintended consequences of this action are monumental. It seems impossible to “de-certify” NRSROs and remove ratings from the financial architecture altogether. Ratings are pervasive in the U.S. financial system from banking to insurance, from trust agreements to collateral agreements and investment policies. It is unimaginable to delete their usage.
Banking and Insurance regulators use ratings to evaluate credit quality. So my first question is, “What do the regulators think?”
I think trashing the ratings system seems extreme.
It seems to work for single-obligor securities.
Where the problem lies is in multi-obligor securities.
Let’s enhance and improve ratings for multi-obligor securities.
Let’s recognize what a rating reflects: the probability of default.
The rating is silent on the magnitude of loss.
The 100-year-old ratings system was never able to handle the multi-obligor nature of modern securitization. The inherent flaw in the system was only noticed when housing assets began to depreciate.
Securitization allows for the creation of credit, which enables our modern economy to function. We need to enhance ratings, not eliminate them. In the coming days, we’ll need to watch the hearings closely.
Please watch the video of Congressman Frank’s CNBC interview on 9-21-2009 where he initially put forth these projections:
Brian – Actually, it doesn’t matter who pays – costs are fungible. What matters is who has the risk. If the rater has skin in the game, it won’t matter who writes the check.
The conflict in interests arose because the raters had no stake (beyond reputation) in the quality of their ratings. Obviously, reputation matters – it accounted for the high credibility that the agencies enjoyed before they went south. But the late unpleasantness has put people in a state of mind where the actual dollar incentives of facing actual human beings will be given the greatest weight by the market.
My UL model is not a “user pays” approach. Issuers pay for credit enhancement. I’m merely suggesting that the rater have a financial stake in investment results, and, of course, that the people who make the call get paid on those results and not on issuer-paid revenues.
All of these changes will be judged by the bond markets, which will believe the ratings or won’t. The spread between corporate and Treasury rates will measure the confidence that the raters have earned.
Lawrence- Great point. The Congressional examination will really focus on the easy to illustrate “conflict of interest”. Certainly the ratings agencies were gamed, or duped. The ratings agencies level of complicity is to be fully discovered. They were also under earnings pressure and sought higher fee business. It doesnt look good. There are legal avenue of prosecution if laws were broken. To your point, I think there is room for the “Issuer pays” and “user pays models”. Lets have the market decide. We need to focus part of the fiducuary duty back on the investors.
HOWEVER; The effects of the downgraded, high quality assets is partially what ailes the economy generally. Lets use the system we have, but improve it.
thanks for the comment.
As a long-time blamer of the ratings agencies, I suggest that the key concern should be the confict of interests inherent in the agencies’ business model, not the advent of novel multi-obligor debt. It may, indeed, be impossible to rate multi-obligor debt, or at least to rate it AAA, but it certainly was possible to decline to rate it, and the agencies might have done so if they didn’t have fees dangling in front of them.
The refusal of the agencies to rate the debt would have brought about a new way of homogenizing the paper, which still needs to be found, as our trading partners still have all the money and still want safe, homogenized debt, as evidenced by the ridiculously low rates on Treasuries.
I think the solution is something akin to Underwriters Laboratories, an agency funded by credit enhancers. I reach that conclusion from the premise that the credit insurers are the only ones with enough skin in the game to care about the quality of the paper, and that too much duplication of effort by all of those insurers would be wasteful, so they should pool at least the threshhold aspects of the underwriting process.
(This is my first comment, and I hope my HTML works. A preview option might be a good addition to this site.)