Monday, October 20th, 2008
agents of record

A recent conference on fixed income organized by the CFA Institutethe research puzzle | This is the third dispatch regarding the conference. The previous ones were “a nasty habit” (link provided) and “rethink everything.” included a fair bit of bashing of the credit rating agencies by the presenters. The assembled investment professionals seemed of a mind to award ratings of “D” to the issuer-paid firms (for a collective default on their analytical obligations).

Had they had the floor, the spokespeople for the agencies surely would have responded (as they have in the past) by pointing out that they really aren’t supposed to do the things that a very high percentage of the users of their ratings expect them to do. In the universe of investors, the attendees of the conference are the ones least in need of accurate ratings from the credit firms, since the asset management companies they work for earn sizable fees and can afford to hire analysts to do independent credit research. The real victims of the inadequacies of the current system are the users that lack those advantages, and who have come to think of the rating firms as their agents of record, providing statements of creditworthiness on which they rely. That’s why investment policy statements for almost all institutions (of every size) include guidelines based on credit ratings, and why individuals buy mutual funds with a ratings distribution that fits their notion of risk.

While there have been plenty of concerns expressed about the rating agencies before, the fiasco in the structured finance market has laid bare all of the issues for re-examination.Perhaps I should have said the “ongoing” or “to-be-continued” fiasco, since one speaker pointed out that the vast majority of subprime CDO tranches are still rated “AAA.” One element of dissonance is that the major credit rating agencies get access to material nonpublic information to form their opinions, but are careful to draw lines about the nature of the due diligence they perform and what users should expect. If that is the case, the ratings shouldn’t be used as they are throughout the investment business, since the firms have in effect walled themselves off from avenues of inquiry that would be logical to pursue.

The question always arises: Are these headline-making failures because of conflicts of interest inherent in being paid by the issuers of the securities (as the big players in the industry are)? Unfortunately for the firms, in every credit cycle there are things that point to that being a big part of the problem, including this time around, when it appears that there was significant “ratings shopping” for CDOs.The grade inflation resulted from a process summarized by one presenter as “going to three agencies and saying, ‘I’m only going to pay two,'” with the implication being that the firm that gives the least AAAs in the structure being considered is out of luck and doesn’t get paid. It is possible that the issuer-paid model could be modified in ways that would improve the results, but the user-paid model seems preferable,Egan-Jones Ratings | Sean Egan, the relentless advocate of user-paid research, was a speaker at the conference. (His firm was designated an NRSRO at the end of last year.) The most interesting topic that he discussed was his firm’s nascent work on “new money ratings,” which are overdue in the marketplace. although there are important concerns about what a wholesale move to that approach would mean for the availability of ratings.

One easy example of the mismatch between the expectations of the firms and the users involves money-market mutual funds, where a large proportion of highly-rated securities is required by regulatory authorities. (Note that it hasn’t prevented the emergence of significant problems in many of those portfolios of late.) While mandates like that don’t exist to the same degree elsewhere, there is a widely-held belief by users that ratings created by entities that have the title “Nationally Recognized Statistical Ratings Organization” will help them to navigate troubled waters. Yet, when turbulence appears is when we find that such reliance can result in a shipwreck.

Forming and publishing investment opinions is difficult business, and the rating agencies are entitled to their share of mistakes. However, despite the competitive advantages they have, they seem to be congenitally late in recognizing when something is amiss, and incapable of fulfilling the mission envisioned for them in the current market structure.

This is a tough time to consider major reform — with so many other policy balls already in the air — but incremental efforts at improving the system leave a shaky premise at its core. Minor changes in the regulatory regime can help, but investors will still be relying on ratings that are unlikely to have the information content that they expect. A more radical rethinking is in order.