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Probably the least discussed aspect of the recent market crash is the role played by the credit rating agencies (CRA’s).  While some on Wall Street were hard at work creating exotic bonds and investment products that included bundles of toxic, subprime mortgage loans, the CRA’s were providing the necessary cover for these instruments to be bought in large volumes by providing them with stellar, ‘objective’ ratings.

Traditionally, credit rating agencies–such as S&P, Moody’s and Fitch–served as a sort of signal or barometer for investors as to the level of risk attached to specific corporate bonds.  Over time, they began rating additional types of investment products, including new financial instruments such as collateralized debt obligations (CDOs) that consisted of massive bundles of subprime mortgages.  Amazingly, these agencies rated these products AAA–the highest possible rating, indicating “the highest level of capacity of the obligor to honor its financial commitment on the obligation.”  The importance of this cannot be understated.  What makes this particularly troublesome is that the firms that issued the debt were the ones paying the CRA’s for the ratings, creating a significant conflict of interest.  Common practice, sure.  But given what transpired in this particular case such a conflict cannot help but be scrutinized.

What was once a reliable indicator for measuring the level of risk attached to an investment has now come into question as possibly nothing more than a rigged instrument.  Now, US Congressional leaders are focusing aspects of their financial reform bill on the CRA’s.  Senator Dodd’s version of the bill included a number of provisions aimed at restoring trust and confidence in these vital agencies.  Just yesterday, the Senate passed an amendment offered by Sen. Franken (MN) that would require a newly-formed government body to assign the task of rating a specific asset-backed security to a specific CRA.  The hope is that such a move would end the practice of ratings shopping that many believe led to creation of perverse incentives by CRA’s and the misleading rating of unstable securities.

I am not by any means an expert on the CRA industry (I know just enough to be dangerous, I guess), but here is my take.

The overall goal should be to create a ratings system that is both widely used and viewed as credible by the investment community. The major issue here is that we need to end the conflict of interest (or perception thereof) that exists when you have a ratings agency being paid to evaluate and rate the level of risk of a complex financial instrument by the very organization that is issue the instrument.  I think the Franken amendment is coming from the right place, but in the end it might be misguided.  Creating a federal agency to determine who gets to rate which security may continue and further perpetuate the false sense of security that investors have in the accuracy of these ratings.  The governmental seal of approval can also induce perverse behvavior.

What I would suggest is the creation of an agency that would manage the oversight of CRA’s in a way that still allows for the market to not only evaluate risk but also evaluate the CRA’s and the ratings they issue.  Here are a few approaches that I think would be helpful:

  • (Good) Require multiple ratings for any single security: As with anything, there is power in numbers.  If the government agency is going to determine who rates a single security why not involve more than one firm?  Why not three CRA’s and the eventual rating is some kind of weighted average of all three?  This could help remove the false sense of security from the government seal as well as the conflict of interest between issuer and CRA.
  • (Better) Provide greater transparency into the ratings process: A better understanding of how the CRA came to it’s conclusion would allow investors to contextualize the rating and how reliable that rating is.  How we cast the die is important when it comes to risk analysis.  Knowing the model, the assumptions, and the data sources provides investors a chance to weight how reliable the rating actually is.  Even if the issuer pays off the CRA investors can independently evaluate the reliability of the particular rating.  Requiring a standard period of review before the security is available for sale would allow for independent evaluation.
  • (Best) Institute rigorous evaluations and independent rankings of ratings agencies (Moneyball-approach): Right now I believe the federal government can register a CRA, but lacks the tools and ability to continuously evaluate and possibly deregister a poorly performing CRA.  What we should be able to do is come up with a way to rank CRA’s against each other based on the reliability of their risk assessment for securities over time.  Think of it as a Value-Over-Replacement-Rater or VORR, similar to the way that professional athletes are now rated and their value determined (Value-Over-Replacement-Player or VORP).  Given the mass of historical data on securities ratings and their performance it shouldn’t be too hard to create a VORP-like rating system that could be updated in real-time as the value of securities rise and fall.  This way, it isn’t simply a government’s stamp of approval or a firm’s reputation that determines the level of trust investors should have in a CRA’s ratings.  Instead, investors can see in real-time how reliable a firm’s AAA ratings are versus the average CRA.  With such a methodology we might be able to avoid both the government providing a misleading seal of approval as well as the damaging conflicts of interest between raters and issuers.  Issuers could still shop around, however if they choose to use a CRA that will give them a favorable rating but has a very low, public VORR they will likely suffer in the end as investors will be less likely to buy the security.  In fact, you would likely see the buy-side institute rules that incorporate VORR ratings into their buy decisions (i.e. no security may be purchased if rated by a CRA whose VORR is less than X).

Like I said, this is not an area I know particulary well.  Any readers at there more steeped in the CRA area that can offer some perspective.

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