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News last month that the Department of Justice is suing Standard & Poor’s for fraud in connection to the ratings of a certain class of mortgage-related bonds was well received by some investors. However, it would be naive to get too excited. The fact remains that five years after the onset of the subprime crisis, the rating agencies still control the fixed-income market.
Far worse, the three agencies that dominated the market before the crisis (S&P, Moody’s, and Fitch) still do so. Newcomers such as Kroll Bond Ratings, Egan-Jones and DBRS remain niche operators, notwithstanding the merits of their technical capabilities.
The US Congress is responsible for this lack of competition. US legislation requires that, before a rating agency can achieve the desired Nationally Recognised Statistical Rating Organisation (NRSRO) status, it must demonstrate a three-year operating record with paying customers. In short, they must show that for three years they managed to survive selling unofficial (ie, useless) ratings. I cannot think of any other market with more stringent entry barriers.
Another uncomfortable fact: the three leading rating agencies rate structured products such as collateralised debt obligations using, allegedly, different methods and proprietary data. However, a casual inspection of their ratings’ records shows a remarkable consistency. How do we interpret this anomaly?
The reputation of the agencies was left in tatters after the subprime crisis. Regulators did not fare any better. After all, they were supposed to oversee the rating agencies and failed miserably at this task. With that as background, it is not surprising that now regulators are trying to appear proactive. But their limited understanding of the technical aspects of this market have forced them to focus on qualitative issues, while missing the more important quantitative issues.
They keep talking about conflicts of interest within the agencies, the problems with the current issuer-pays rating model, and the consequences of deteriorating mortgage-underwriting practices. However, even if these issues were successfully addressed, the credit ratings edifice still has much more fundamental problems.
For example, several studies have shown that the credit metrics (risk management jargon for measure) currently used by the rating agencies have severe theoretical shortcomings. In technical terms, they are not “coherent” (they lack certain desirable mathematical properties). Moreover, recent research has shown that the credit ratings of structured products are extremely unstable. A minor variation in any input data can change the resulting rating by several notches, sometimes, even crossing the investment grade-junk border. This is a very unwelcome property as ratings are normally used to trigger liquidation events, assess reserve levels, and dictate collateral requirements. Further, the lack of consistency across ratings of different instruments (municipal bonds and CDOs, for example) creates a number of regulatory arbitrage opportunities.
Much fresh thinking is needed to improve the ratings environment. First, a new set of more robust credit risk metrics should be adopted to issue structured product ratings (practitioners and academics have made important progress in this topic). Ratings based on more stable metrics will be less likely to trigger systemic instability.
Second, corporate bonds, municipal and sovereign bonds, and structured products are completely different instruments. Accordingly, their ratings should be based on a different credit risk framework (and perhaps even the rating scale and symbols should be different).
Third, regulators should define, objectively, a credit risk scale. The rating agencies should only be allowed to state, based on whatever methods they see fit, the category in that scale to which an instrument belongs. This is a radical departure from the current situation in which the agencies control two things: first, the ratings scale (for instance, the precise definition of what triple A means), and second, whether a specific instrument meets that definition or not.
Finally, regulators should create a centralised web-based data repository where any market participant could download for free all current and historic ratings data. This initiative would promote not only the development of better models, but will also facilitate testing them.
Some of these observations might appear excessively technical, or even pedantic. But after a trillion-dollar disaster one should get technical and stop talking in platitudes. The reality is that the credit ratings framework needs to be redesigned almost from scratch.
Arturo Cifuentes is a member of the Academic Committee, Financial Regulation Center, University of Chile.
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