Former rating agency worker: no fundamental changes have been made since the financial crisis hit

In a Guardian interview, a former rating agency worker expresses fear for the stability of the financial system by noting that there has been no fundamental change since the financial crisis hit.

Regular readers know there has been one change.  The prescriptive financial regulatory industry has grown by leaps and bounds.  Look at all the detailed regulations that are being churned out under Dodd-Frank.  By doing so, they have protected opacity across large areas of the financial system.

"I was on holiday in the runup to the collapse of Lehman Brothers, when the crisis exploded. I remember opening up the paper every day and going: 'Oh my god.' It was terrifying, absolutely terrifying. We came so close to a global meltdown. .... 

Now here we are four years later, and the most incredible thing has happened – we've learned nothing from the whole thing. Everybody pretends it's all OK. ... 

"If you had told people at the height of the crisis that four years later we'd have had no fundamental changes, nobody would have believed you. Such was the panic and fear. But there we are. We went from 'We nearly died from this' to 'We survived this'. 

It is a real testament to the power of the prescriptive financial regulatory industry that they were able to block the return of transparency to all the opaque corners of the financial system.  Instead, we have a bunch of one-off regulations that attempt to achieve what transparency would do.  


For example, we have issuers retaining an interest in structured finance securities.  The reasoning being that this will give the issuers an incentive to underwrite less toxic junk.

If there were true transparency into the underlying collateral, investors would not care whether the issuers retained an interest or not.  With true transparency that includes observable event based reporting, investors could assess the risk of the underlying collateral and know what they own.

If a deal includes high risk assets, the investor would demand a return that compensated them for the risk of the assets.

"Have you read Gillian Tett's Fool's Gold about the crisis? It was exactly like that. You had bankers who did not understand their own complex financial products but thought that they did, and then raters who took their word for it. And nothing has fundamentally changed.  

"As most people understand by now, lots of sub-prime mortgages were bundled by banks into financial products and sold on to investors. These believed they bought a very safe thing because the products had been rated triple A, which meant that there was only a 1% or so chance of a default. 

"When the crisis hit, it hit hard, reality kicked in and the rating agencies suddenly downgraded triple A products to junk status in a matter of days. I won't call it fraud; I will call it a 'desperate revision of history'. 

In the absence of transparency into the underlying collateral, investors turned to the rating agencies who  failed to inform the investors that they had no better access to information on the underlying collateral than did the investors.

This was not clarified until the fall of 2007.

"Overall, it was more incompetence than outright fraud. .... As far as the rating agencies were concerned, it was incompetence brought on by short-termist, bottom-line thinking by senior management who just wanted to make money. That meant rating as much as possible, as often as possible.... 

"When asked about the crisis, rating agencies use the defence that the bankers who designed those complex financial products did not understand them themselves. So how can rating agencies be blamed for not understanding them either**? 

"But you shouldn't just rely on the information given to you by the people whose product or company you are rating.... 

"With every new financial product, raters should be asking: have the products been tested properly? Are they modelled for all possible conditions, so boom as well as bust times? Do we even know what it does in every phase of the economic cycle? Do we know how the product is likely to evolve over time, how will it behave when it develops into a bubble?

Investors should be asking the same questions.  In addition, investors should not invest unless they are sure that there is transparency so that they have access to all the useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.

Former head of S&P structured finance: Ratings aren't meaningful or trusted

As reported by Bloomberg, the bottom line on credit ratings from David Jacob, the former head of structured finance at S&P is

“[Rating companies are] there because people have to have them, not because people believe in them,” ....  “Maybe retail investors do, that’s the unfortunate part, but I think institutional investors don’t.”... 

Jacob, hired four years ago to help restore confidence in S&P, says policy makers haven’t gone far enough to reduce reliance on the ratings companies, granted the authority by U.S. regulators 76 years ago to determine which borrowers deserve credit.....

“Ratings are not God’s holy work,” said Jacob, 56, a graduate of Queens College in New York with degrees in math and finance from New York University. “It’s a business. It’s a fine balance between trying to get a certain amount of market share versus losing your credibility.”...

It is a business that would change considerably if more transparency were brought into all the opaque corners of the financial markets.

With everyone having access to the same information, the rating firms would have to show they add value through their analysis.

“Moody’s is not going to detect some problem in advance and move a rating to warn the public,” said Fisher, whose firm manages about $44 billion. “Whether it’s a stock or a bond, the free market already did that. Moody’s goes along afterwards and effectively validates what the market’s already done.”... 

 The clear perception is that the rating companies are a lagging indicator at best.

S&P President Douglas Peterson said at a meeting of the Institute of International Finance in Copenhagen on June 6 that ratings companies help ensure that bond issuers provide “transparent information” under “strict standards of governance and control.”... 

Transparent information to whom?

Historically the rating companies model has been built not on public disclosures by the borrowers, but rather that the rating firms have access to information that is unavailable to other market participants.

Jacob joined S&P after managing commercial- and residential-mortgage bond groups at Nomura Holdings Inc. from 1993 to 2007. He said he sought to ensure that S&P analysts didn’t loosen standards at the request of bankers. The firm won less business in certain areas as a result. 

“We’ve swung back from where it was before when it felt more like the Wild West, but of course it puts a crimp on the business,” Jacob said in the interview last month. “It’s important for investors to watch to see if there’s a change and a shift in terms of trying to rebuild that market share.”....

The path to rebuilding market share is by loosening rating standards.  We saw how well that worked in structured finance leading up to the financial crisis.

Grading government bonds is outside ratings companies’ traditional areas of expertise, Jacob said. 

“You’re talking about politicians, you’re talking about legislators, you’re not talking about credit risk,” he said. “I don’t see how a rating agency has any better call on it than you or me or anybody else.”... 

Jacob said he is now considering working in financial regulation. 

One reform that would improve the quality of ratings would be to have all scores correspond to percentage chances of default, rather than the vague definitions now in use. S&P says its top rating means the issuer is “extremely strong,” while Aaa bonds are considered “highest quality” at Moody’s. 

“I was there three and a half years and I still don’t understand it,” Jacob said. “When people can use the same set of letters and mean entirely different things, then they become useless.”

Bottom line:  rating companies are another layer of opacity in the financial system.

Moody's bank credit rating downgrades highlight need for ultra transparency

A reported by the Telegraph, Moody's lowered the credit ratings on Britain's biggest banks.

This change in ratings highlights two lessons learned at the beginning of the financial crisis.

• Ratings lag what is actually occurring; and
• The market is still overly dependent on ratings.

Both of these lessons are addressed by requiring the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this information, rating firms have no excuse for not changing their ratings on a timely basis.

With this information, market participants can independently assess the risk of the banks and as a result there is no need to rely on the rating firms.

Britain's biggest banks, including Barclays, Lloyds and the Royal Bank of Scotland, have had their credit ratings slashed by Moody's as part of a worldwide review of bank credit ratings....

In a statement, Moody's global banking managing director Greg Bauer said: "All of the banks affected by today's actions have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities.".... 

However, as the review was announced in February, the impact on borrowers is likely to be muted as the downgrades were already priced in by the market.

Confirmation that transparency reduces relevance of rating firms

A Bloomberg article confirms that the more transparency provided to market participants, the less relevant the rating firms are.

The response to the Moody’s Investors Service downgrade of the biggest Nordic banks was rising bond and share prices. 

The reaction is the latest sign that investors are paying less attention to the views of rating companies and relying more on their own analysis to determine whether to buy or sell.

“We can see for ourselves just how strong the Swedish banks are so we don’t place much weight on what rating agencies tell us,” Nicklas Granath, a partner at Stockholm-based asset manager Norron AB, who helps manage about $200 million, said in an interview. “More and more the market is likely to take the same approach.” 

Even though Sweden doesn't require the banks to provide ultra transparency, it has a history of requiring the banks to recognize the losses hidden on and off their balance sheets.

As European policy makers try to reduce the dominance of rating companies in financial markets, investors are showing greater willingness to ignore Moody’s, Standard & Poor’s and Fitch Ratings.... 

“The Nordic banks are in general very solid and have currently no issues in funding,” said Espen Furnes, an Oslo- based fund manager at Storebrand Asset Management, which oversees $72 billion. “Moody’s is knocking down open doors with this. In these volatile markets the rating agencies are definitely behind the curve and, strangely enough, could be at risk of being considered irrelevant by the market during times when they actually do have something critical to say.”...

Keep in mind that the rating firms' business model is currently built around the idea of access to proprietary information.  Prior to their ratings being changed, banks have a chance to present the facts that they feel merits a higher rating.  Facts that are not always available to all market participants.

In Denmark, banks have started firing Moody’s after winning assurances from some of the country’s biggest investors that the opinions of ratings companies hold limited value.... 

Swedish banks, still among the best-rated in Europe, are now signaling they may rethink their cooperation with the rating company.

Cooperation that results in the rating firms having an informational advantage compared to other market participants.

“It is hard for” rating companies “to keep track and when you come close to them it is quite apparent they have difficulty following everything that is happening elsewhere,” [Swedbank Chief Financial Officer Goran] Bronner said. “The key is more transparency and then the market can decide.”

In particular, ultra transparency under which the banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With ultra transparency, the market participants have access to all the information they need to independently assess the risk of each bank.

'Start your own rating agency' Moody's tells governments

In a Telegraph article, Richard Blackden reports how Moody's is challenging governments who complain about the rating agencies to start their own.

Ray McDaniel, the chief executive of Moody's, described the conditions under which such an agency needs to operate

To win the confidence of financial markets, such an agency would have to ensure it was independent of governments and that its opinions were widely available.

The governments should take Mr. McDaniel up and do him one better.

Rather than set up a single rating agency, the governments should adopt ultra transparency across the financial system and create the environment under which many new rating agencies can be formed.

By eliminating the barrier to entry to the rating business, which is access to information and not analytical expertise, the new rating services can use the Internet to globally disseminate their ratings.

Adopting ultra transparency is consistent with the role of governments under the FDR Framework.  Furthermore, under this framework governments are explicitly barred from offering their opinion about an investment.

The reason for this explicit ban is it creates moral hazard.  For example, let's look at what happens when governments announce the result of bank stress tests.  The governments become morally committed to bailing out depositors, bond holders and equity investors should the bank run into solvency problems.

Adopting ultra transparency and expecting new rating agencies to form is also consistent with the FDR Framework.  Remember that under this framework, investors are responsible for all gains and losses.  As a result, they have an incentive to use the data made available through ultra transparency.

Naturally, if they are unable to assess the data themselves, they are likely to use a third party expert... hence, there is a demand for the new rating services.

"Public institutions that have both the expertise and credibility among market participants should provide views on sovereigns," said Ray McDaniel, the chief executive of Moody's. 

To win the confidence of financial markets, such an agency would have to ensure it was independent of governments and that its opinions were widely available, Mr McDaniel wrote in a paper called 'A Solution for the Credit Rating Agency Debate.' 

The suggestion from the head of one of the world's big two agencies is both a rebuke and a challenge to governments who have lambasted the agencies. 

European leaders, led by French President Nicolas Sarkozy, have accused them of deepening Europe's debt crisis by downgrading the ratings of key countries in the euro. 

"Rather than stifle those opinions, policy makers should neutralise private-sector rating opinions by introducing a public-sector voice to contribute competing views," according to Mr McDaniel.... 

Some European critics have argued that the agencies should be banned from making public their opinions on the creditworthiness of governments, but Mr McDaniel argued that will not stop investors from speculating and making their own judgements. 

In the paper, Mr McDaniel suggested that establishing a public credit rating agency was down to the strength of political will there is to do it. 

The agencies have faced a wave of criticism from European governments over the last 12 months, and this week the European Union's top markets regulator delivered its own warning. 

The European Securities and Markets Authority said that the companies must improve their internal processes or face possible action from the regulator. Moody's said that it was committed to "continuing to enhance its rating process."

Global policymakers and financial regulators as barriers to ending financial crisis

The Guardian ran an interesting column by Ha-Joon Chang in which he examined the role of Eurozone policymakers and financial regulators in perpetuating the financial crisis.

... Nevertheless, France has some grounds to be aggrieved [about losing its AAA-rating], as it is doing better on many economic indicators, including budget deficit, than Britain. And given the incompetence and cynicism of the big three exposed by the 1997 Asian financial crisis and more dramatically by the 2008 global financial crisis, there are good grounds for doubting their judgments. 

However, the eurozone countries need to realise that its Friday-the-13th misfortune was in no small part their own doing. 

First of all, the downgrading owes a lot to the austerity-driven downward adjustments that the core eurozone countries, especially Germany, have imposed upon the periphery economies. As the ratings agencies themselves have often – albeit inconsistently – pointed out, austerity reduces economic growth, which then diminishes the growth of tax revenue, making the budget deficit problem more intractable. The resulting financial turmoil drags even the healthier economies down, which is what we have just seen. 

Apparently, the same theory of trying to 'cut your way to profitability' that doesn't work for companies also does not work when extended to nations.

Even the breakdown in the Greek debt negotiation is partly due to past eurozone policy action. In the euro crisis talks last autumn, France took the lead in shooting down the German proposal that the holders of sovereign debts be forced to accept haircuts in a crisis. Having thus delegitimised the very idea of compulsory debt restructuring, the eurozone countries should not be surprised that many holders of Greek government papers are refusing to join a voluntary one. 

When the financial firewall is built not to protect bank book capital, but rather bank depositors, the idea of forcing holders of sovereign debt to accept haircuts is not only legitimate, but expected.

On top of that, the eurozone countries need to understand why the ratings agencies keep returning to haunt them. Last autumn's EU proposal to strengthen regulation on the ratings industry shows that the eurozone policymakers think the main problem with the ratings industry is lack of competition and transparency. However, the undue influence of the agencies owes a lot more to the very nature of the financial system that the European (and other) policymakers have let evolve in the last couple of decades. 

First, over this period they have installed a financial regulatory structure that is highly dependent on the credit ratings agencies. So we measure the capital bases of financial institutions, which determine their abilities to lend, by weighting the assets they own by their respective credit ratings. We also demand that certain financial institutions (eg pension funds, insurance companies) cannot own assets with below a certain minimum credit rating. All well intentioned, but it is no big surprise that such regulatory structure makes the ratings agencies highly influential. 

The Americans have actually cottoned on this problem and made the regulatory system less dependent on credit ratings in the Dodd-Frank Act, but the European regulators have failed to do the same. It is no good complaining that ratings agencies are too powerful while keeping in place all those regulations that make them so. 

The Eurozone policymakers are right that transparency is the key to reducing the influence of the rating agencies.  However, it is not transparency into how the rating agencies reach their conclusions.

Rather it is transparency where all market participants have access to all the useful, relevant information in an appropriate, timely manner.  Were this type of transparency in place, rating agencies would not have access to information that is unavailable to the rest of the market participants.  As a result, the rating agencies would become just another market participant with an opinion.

Most fundamentally, and this is what the Americans as well as the Europeans fail to see, the increasingly long-distance and complex nature of our financial system has increased our dependence on ratings agencies. 

In the old days, few bothered to engage a credit ratings agency because they dealt with what they knew. Banks lent to companies that they knew or to local households, whose behaviours they could easily understand, even if they did not know them individually. Most people bought financial products from companies and governments of their own countries in their own currencies. 

However, with greater deregulation of finance, people are increasingly buying and selling financial products issued by companies and countries that they do not really understand. To make it worse, those products are often complex, composite ones created through financial engineering. As a result, we have become increasingly dependent on someone else – that is, the ratings agencies – to tell us how risky our financial actions are. 

This means that, unless we simplify the system and structurally reduce the need for the ratings agencies, our dependence on them will persist – if somewhat reduced – even if we make financial regulation less dependent on credit ratings. 

Please re-read the highlighted text because it makes a very important observation about how we have moved from a transparency based financial system where everyone did their own analysis to a regulator embraced, opacity based financial system where everyone is relying on third parties for analysis.

The way to move back to the system that worked is for the regulators to embrace transparency.

The eurozone, and more broadly Europe, is slowly strangling itself with a toxic mixture of austerity and a structurally flawed financial system. Without a radical rethink on the issues of budget deficit, sovereign bankruptcy and financial reform, the continent is doomed to a prolonged period of turmoil and stagnation.

Will adding a label indicating minimum standards entice investors to buy European ABS deals? No!

A Bloomberg article reports that European issuers of ABS securities and a broker/dealer controlled lobbying group, the Association for Financial Markets in Europe, want to introduce a label indicating that the assets backing a structured finance deal meet a minimum standard.  According to the article, they are doing so to make the ABS securities more attractive to buyers.

There is zero chance that labeling the ABS securities will make them more attractive to investors.  This is just another attempt by the issuers and Wall Street to avoid having to disclose the current performance of the underlying collateral.

Why will this label not make the securities more attractive?

• The minimum standards for the underlying assets are already covered by the representations and warranties made in the deal documentation.  Since the information is already in the deal documentation, the label offers absolutely zero new information.

• The fact that the underlying assets met the minimum standards at one point in time does not mean that they still meet this standard at a future point in time.  For example, look at the decline in performance for so-called Prime mortgages in the US.  A label conveys zero useful information for valuing a deal in the secondary market.  Without current performance data, investors in the secondary market are blindly betting on the contents of a brown paper bag.

Disclosure of current performance data for the underlying collateral is the only way to entice investors to buy ABS securities.  It is only when investors know what they own that they will return.

The Association for Financial Markets in Europe and European Financial Services Round Table lobby groups are working on plans to label asset-backed notes that reach certain standards as Prime Collateralized Securities, according to two people familiar with the matter. 

A PCS working group, which also comprises investors, is scheduled to meet today to discuss the timing for the project and how to get better regulatory treatment for the debt, said the people, who declined to be identified because the discussions are private. 

The industry groups are working on the quality-assured brand after issuance in the asset-backed securities market in Europe tumbled by more than 80 percent since its pre-credit crunch heyday. Sales stalled in 2008 after bonds linked to U.S. subprime debt slumped, prompting investors to shun the hard-to- value securities. 

“In principle it’s a good initiative, but the implementation is very complex because of the different market practices in each European country,” said Alexander Batchvarov, the London-based head of structured finance research at Bank of America Corp. 

The PCS label would be designed to take account of new and existing regulation, said the people. Deals would need at least two triple-A credit ratings and reveal enough information about the underlying loans to be eligible for the liquidity operations of the European Central Bank and Bank of England, the people said. The ECB, BOE and European Investment Bank have been consulted on the plan, according to the people. 

As this blog has previously documented, the ECB and BoE have disclosure requirements for the underlying loan performance information that are inadequate for complying with Article 122a of the European Capital Requirement Directive.  Both Moody's and S&P have testified before Congress that these disclosure requirements are not adequate for timely rating (the equivalent of valuation) of the securities.

The inclusion of two triple-A credit ratings does not make ABS securities more attractive.  Investors learned from the sub-prime/CDO debacle to not rely on the credit ratings when it comes to valuing and investing in structured finance securities.

... The quality tag will be available for bonds backed by residential mortgages, small- and medium-sized company loans and consumer loans, the people said. 

“To make this initiative work it’s key to get the ECB and BOE to give the labelled issues better treatment in their liquidity operations, or to persuade the European Commission to require less capital for banks and insurance companies that buy these bonds,” Bank of America’s Batchvarov said.

Since September 2008, the ECB and BoE have been the major "buyer" for these securities. These securities are "purchased" by being eligible to be pledged to the ECB and BoE for their liquidity operations.

The goal of the ECB and BoE is to bring private investors back to the market so that they do not have to fund these securities.

Simply slapping a label on these deals will not work to attract investors.  The ECB and BoE know that it will take disclosure of current performance data for the underlying assets.

SEC looks at S&P use of 'dummy' assets in rating CDO

The Wall Street Journal reported that the SEC is looking at S&P and its use of 'dummy' assets in rating CDOs.

Whether or not the SEC pursues this case against S&P, the use of 'dummy' assets makes the case for asset level (loan-level) disclosure for all structured finance securities.  Simply put, the SEC is looking at the issue of how can you value/rate a security when you do not even know what is in the security.

Your humble blogger has been making this point about the need for current asset-level disclosure for structured finance securities since before the credit crisis.  Without this disclosure, market participants do not have all the useful, relevant information in an appropriate, timely manner.

It is nice that the US government in the form of the SEC has come out and formally agreed with me on the need for current asset-level disclosure for structured finance securities.

U.S. securities regulators are zeroing in on the use by Standard & Poor's of fictitious "dummy" assets when it assigned a triple-A credit rating to a $1.6 billion mortgage-bond deal that imploded during the financial crisis, according to a person familiar with the matter. 

S&P's parent company, McGraw-Hill Cos., said Monday that it had received a so-called Wells notice from the Securities and Exchange Commission. A Wells notice is the agency's warning to financial institutions that they could face civil charges. McGraw-Hill said the SEC is weighing civil enforcement action against the firm for its ratings on a collateralized debt obligation called Delphinus CDO 2007-1 issued in July 2007 as the housing market was taking a turn for the worse. 

The SEC is alleging violations of federal securities laws, McGraw-Hill said in a news release. The company said S&P has been cooperating with the regulator on its probe into Delphinus. A spokesman for the SEC declined to comment.

Lawmakers, regulators and investors have trained their cross hairs on S&P and its peers for assigning rosy ratings to thousands of complex securities that were later downgraded within the span of a few months, deepening the crisis. 

The S&P investigation is one of a number of probes by the SEC's enforcement division, headed by Robert Khuzami, into the complex mortgage-bond deals known as collateralized debt obligations. 

CDOs, which are pools of subprime mortgages and other assets that were sold in slices to investors, had emerged before the crisis as popular and profitable products on Wall Street. But the housing market's collapse exposed both the banks and their investors to billions of dollars in losses and left in its wake a raft of legal and regulatory headaches. 

S&P originally assigned its highest rating to the deal based on "dummy," or hypothetical, assets, then maintained that triple-A rating even though bankers had replaced them with lower-quality assets that didn't meet the firm's ratings standards, according to emails among S&P analysts that were disclosed in congressional testimony. 

Jack Chen, a former Moody's analyst who now runs his own consulting firm, said it isn't uncommon for credit-rating firms to use "dummy" assets to determine a final rating for a CDO, because some of the deals may have assets traded in later. 

What is problematic with S&P's rating of Delphinus is that the assets that replaced the "dummy" assets were of a lower quality than those hypothetical assets S&P had used to issue the ratings, said Mr. Chen, who has reviewed the S&P emails that were released. 

Frank Raiter, a former S&P managing director who had retired by the time Delphinus was rated, told lawmakers in April 2010 that S&P's dependence on fictitious assets that were later replaced by lower-quality securities "looks like a bait and switch."

Had the investors had current asset-level data, it would not have been possible to do a bait and switch.  Investors would have been easily able to see that the assets did not meet the quality standards that were represented in the offering documents and would not have purchased the deal.

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.