Fixing the credit-rating system

Francesco Guerrera wrote a column for the Wall Street Journal in which he discussed what to do with the rating agencies.  His column closely parallels this blog's discussion on this topic under the FDR Framework.

Regular readers know that this is a non-issue under the FDR Framework.

Under the FDR Framework, governments are suppose to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  For their part, market participants have an incentive to analyze this information because, under caveat emptor, they absorb the loss if an investment loses money.

Please note, market participants do not have to do this analysis themselves.  They can hire third parties to do it for them.  A practice that is very common today - for example, mutual funds.

In a perfect world, Standard & Poor's wouldn't ... exist. And neither would its rivals Moody's Investors Service and Fitch Ratings Ltd. At least not in their current roles as global judges and juries of corporate and government bonds. 

The historic decision taken by S&P on Aug. 5 is the culmination of 75 years of policy mistakes that ended up delegating a key regulatory function to three for-profit entities. 

75 years ago, the information technology did not exist for fully implementing the FDR Framework.  For example, it would have been impossible to make a bank's current asset and liability-level data available.  So there was a need for a small group of entities with access to information that the rest of the market did not have.

That was 75 years ago.

Today, the information technology exists to provide all the useful, relevant information in an appropriate, timely manner to all market participants.

... The issues highlighted by S&P's action and the markets' panicky reaction can only be resolved by removing rating firms from the heart of the financial system and by encouraging bond buyers to take on more responsibility for assessing the risk of their portfolios.

Under the FDR Framework, bond buyers are given the incentive, because they are responsible for all losses on their investments under caveat emptor, to assess the risk of each individual security.  Ending the global policy of bailing out investors in bank bonds would reinforce this incentive.

First, some history: Unlike most other markets, in fixed income, investors and companies have been able to outsource their brains. 

Since 1936, when bank regulators forbade lenders from buying "speculative investment securities" as defined in "recognized rating manuals," a handful of raters have enjoyed a cozy oligopoly of the "truth" about bonds. 

Their central role was further hard-wired into the financial architecture as insurance regulators, pension watchdogs, the Securities and Exchange Commission and, eventually, the European authorities, ordered their charges to rely on rating firms' opinions before buying bonds. 

The result, as Lawrence J. White, an economics professor at New York University's Stern School of Business, put it in a paper last year, was that financial groups "could satisfy the safety requirements of their regulators by just heeding the ratings, rather than their own evaluations of the risks of the bonds." 

In short, rather than focus on ensuring disclosure under the FDR Framework, regulators focused on eliminating caveat emptor.

The reason why such a patently imperfect arrangement endured is that it benefits all parties involved. 

Bond buyers don't have to do any work other than reading the "Big Three" reports. 

Regulators can sleep easy as long as their subjects comply with the letters of the law—namely As and Bs, the seals of "investment grade" quality. 

Corporate and government borrowers can count on demand for securities with certain ratings. And the rating firms reap annuity-like earnings from being an indispensable cog of the financial machine. 

This web of vested interests came under the spotlight after the disastrous errors committed by large raters during the securitization bubble (triple-A collateralized debt obligations, anyone?).

The arrangement was also a glaring example of regulators gambling with financial stability.  Under the FDR Framework, the analytical resources of the market are applied as oppose to the analytical resources of a few firms that might have a conflict of interest in the results.

The Dodd-Frank law passed in the aftermath of the financial meltdown calls for references to credit ratings in regulations for financial groups to be eliminated and replaced with different ways of gauging a bond's riskiness.  

The rating firms actually support this approach. "It wouldn't undermine our business," Paul Taylor, Fitch's president told me. "If regulatory references were to go away for us as an industry, there would still be strong demand for our product."

Please reread Mr. Taylor's quote as this is a very important point that your humble blogger has made many times.

Demand for analytical services would increase.  We know that when demand increases, so too does supply if there are no constraints on supply.

In the case of bonds, both structured finance and bank related, there is a constraint on supply.  That constraint is the absence of disclosure of all the useful, relevant information in an appropriate, timely manner.

In the presence of disclosure as recommended under the FDR Framework, many firms would offer analytical services.  This includes the large financial institutions.

In a surreal twist, however, it is the regulators and financial institutions that oppose the Dodd-Frank law's laudable and logical aim. They argue that alternatives to the absolute rule of the Big Three would be too costly and put U.S. companies at a disadvantage to foreign rivals. 

Regulators and systemically important financial institutions would have to give up a mutually beneficial relationship.

Regulators would have to give up their information monopoly and the market's reliance on them to properly analyze this information.

Systemically important financial institutions would have to give up their monopoly on explaining to the regulators how to analyze their firm's information.

David K. Wilson, the chief national bank examiner at the Office of the Comptroller of the Currency, told a recent congressional hearing that Dodd-Frank "goes further than is reasonably necessary." 

Mr. Wilson pointed out that, when regulators canvassed financial groups, the general response was that "developing a suitable alternative to credit ratings would be impossible without creating undue regulatory burden." 

Any change that goes from box-ticking to financial analysis would increase costs and impose a "regulatory burden." 

The question is whether it would be worth it. 

There must be room for improvement in a system that vests so much power in so few hands and is easily gamed by both bond sellers, which lobby to get the best possible ranking, and buyers, which shop around for the highest yielding bond within a rating category (the key reason why triple-A CDOs were so alluring). 

Over the last 75 years, where it has been fully implemented, the FDR Framework has shown that it is worth it.

Fully implementing the FDR Framework in fixed income would result in dramatic improvements.

• It would end the market's reliance on a few analytical services.

• It would encourage buyers, particularly institutional buyers with a fiduciary duty, to do their own homework and assess the risk of each investment.

• It would remove, as was FDR's original intention, the government from evaluating the merits of an investment (saying that an investment has to be rated investment grade is the equivalent of evaluating the merits). 

• It would increase financial stability as fear of the unknown would be replaced with the analysis of facts.