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Future of credit raters

Uncle Max

Uncle Max

Joined
6/3/06
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SEC to consider the future of credit raters April 15

Government rater?
A government rating agency could be funded by fees corporations pay to list with stock exchanges. The objective of such an agency would be to rate corporate debt in a way that eliminates the conflict of interest inherent in the relationship between private raters and the corporations' debt they rate.

Rater-picker?
One similar type approach gaining steam would require legislation setting up an independent "umpire-type" entity that would randomly pick a private rater and pay for the rating. The independent entity would be funded by fees from public corporations.
 
The following is my perhaps flawed hypothesis:

I think the existence of the ratings companies is moot by now. Their reputation is shattered like glass to the point that all of the reputable firms now do their own due diligence in-house. Furthermore, who exactly wants to go out and work for a ratings agency? The superstars go to work for the big houses or the boutiques or the hedge funds, and the ratings agencies take the poor sods that don't have the connections to find anything else and don't know anything else to get into anything better.

I'm not even questioning the conflict of interest here--I'm questioning whether or not the ratings agencies can even understand what it is that they are rating! As Jeff Macke on Fast Money says, their opinions matter for nothing, and will *continue* to matter for nothing unless they can sufficiently attract talent away from places like Goldman and DESCo.

Which as private institutions they are currently incapable of doing, and certainly as public institutions won't have a ghost of a chance of doing.

Simply put, they'll be second rate no matter in which instance, shape, or form they appear in, conflict of interest or not. The ratings agencies simply don't have the hope of attracting anywhere near the brainpower that the beaucoup bucks of the all stars do. And no matter what kind of rules they set up, the smarter people at the better firms will simply find a new way of playing regulatory arbitrage and hiding loopholes and radioactive material in plain sight in the way Wall Street is so talented at doing.
 
Rating agencies are not moot by any stretch, and for two reasons.

1. They have privileged information. They get to look at the books, the individual loans, whatever. I as an investor may be lazy and use them because I can't rate every deal myself (all laziness is relative), but even if I weren't and I went to look at all the public information... the rater has much more available to it to make a judgment. So they occupy a unique niche that one cannot duplicate.

2. Their current business model -- paid by the issuers -- everyone agrees is broken. However, we can fix every problem by making them paid by the purchasers. This will cause them to compete on quality, not quantity. Any time they stop working for you, you stop working for them; your incentive is to get properly rated deals not to get highest quality rating, and therefore that is their goal. As a corollary, they will pay for talent, because talent will produce better ratings.

Once you have a business model that requires competition on quality, not on quality, the brain drain has to stop. Why? Item #1 above: there is a demand that will not go away.

If the bailout has shown us anything, it's that if a business can survive on its own without government intervention, it really ought to; government involvement just means politicization. I'm open to arguments to the contrary, but the evidence is very strong in my opinion.
 
doug reich said:
2. Their current business model -- paid by the issuers -- everyone agrees is broken. However, we can fix every problem by making them paid by the purchasers.
Click to expand...

I'm not sure exactly how this would work. Let's say I'm a private investor and I'm interested in purchasing a bond. In your world, I'd have to pay Moody's to get a rating for that bond. But let's say that the bond is rated AAA, and it really is that well-rated because in your world, we stipulate that the ratings agencies are operating efficiently and accurately.

However, this places the bond rating agency and the bond issuers at odds. The bond issuer wants everyone to know how well his (or her) bonds are rated. So the bond issuer buys the rating from Moody's and posts it on the web. Or maybe they hire some blogger to do the same. Or maybe CNBC reports on it, because broadcasting information is what they do for a living. Once that rating becomes public knowledge, why would any private investor, like myself, bother paying money to Moody's to get it? And if the purchasers don't want to (or have to) bother paying, the "purchaser pays" model falls apart. I'm not disagreeing that the current "issuer pays" model is deeply flawed, but I don't think the fix is as easy as you make it out to be.
 
Off the top of my head, have the rating agency paid from the cashflow of the security. If it's a good one, they'll be willing to be further down in the waterfall (capital structure for a bond). For the real trash, they will either need to be paid immediately or they will refuse to rate it. And if they do a bad job consistently, they will go out of business.

Mine is not an original idea; plenty of columnists have written precise suggestions on it, I would think.

Anyway, they'll give much more voluminous opinions and control that data more carefully if it's a la carte. It is done every day with analyst reports and all manner of paid data.
 
In this case raters will force to structure deals with a huge reserve to make sure they will get paid. Which is another extreme from what was before.

The main problem is that there is no competition on credit ratings market. There are very few companies who have government granted NRSRO status. And all major investment companies are required by government to use ratings produced by NRSROs to invest. And it was close to impossible to obtain NRSRO 2 years ago, because Moody's and S&P had lobbyists everywhere.

Therefore, the problem was government who created monopoly on the credit raters market. Now government is trying to solve it by creating another monopoly like government rater. Which will only lead to more corruption and won't improve anything.
 
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