Rating the Credit Raters

By / 5.6.2013

Credit rating agencies (CRAs) are supposed to be hard-eyed accountants whose job is to assess credit risk. But they also got swept up in the euphoria that swelled the housing bubble, failing with the Fed and other market participants to predict the extent of the housing crash. That’s partly because they over-extended the use of AAA-ratings, the highest “grade” given to a structured financial product, which falsely indicated low-risk assets.

Senator Al Franken (D-Minn.) has introduced an amendment to make credit raters more transparent and accountable. But while this amendment has the right intention, whether it could actually work is another question. Even Sen. Franken himself doesn’t seem all that confident that his measure will work. “I would like to emphasize that we hold no pride in authorship,” Franken said in an e-mailed statement. “We will applaud the implementation of any proposal or set of proposals that ultimately protect consumers and the American public.”[i]

The Franken Amendment essentially calls on the Securities and Exchange Commission (SEC) to create an oversight board of the rating agencies. The private sector rating agencies and investment firms would have majority representation. The board would oversee a process where a random firm is selected to conduct the initial evaluation of each new financial product that requires a CRA review. Under the proposal, issuers of new securities aren’t allowed to be involved in this part of the process.

But a public-private coordinated oversight board tucked within the SEC is destined for failure. If the pendulum swung too far in one direction prior to 2007, with issuers and most players underestimating risk, this move swings the pendulum right back. A structure like this is confusing to markets and will easily be seen as the federal government granting a guaranteed seal of approval on all ratings.  Even risky debt might be seen as a viable investment inviting dangerous behavior fraught with moral hazard. The market needs to create the appropriate amount of risk, with appropriate public oversight; this proposed set up will
only exacerbate it.

The two key inputs for a successful formula in a healthy, vibrant and innovative CRA market are transparency and time. There is no such thing as too much transparency when it comes to debt instruments that have a proven track record of impacting systemic risk. The concept of a fully transparent, public site that allows everyone access to real time products in review is essential. This will allow the concept of CRA’s that are not directly involved to periodically review and post their rating on a structured financial product when they have no direct party involvement. This will promote “self-policing”, competition and standards will improve.

Time is a simple acknowledgement that no regulation can immediately affect. We are still essentially in a post-crisis period that has investors operating in a highly risk-adverse environment. But time will slowly change that and that’s a good thing. Encouraging responsible risk-taking is how innovation thrives, the economy grows, and jobs are created.

It’s time to take a serious look at what’s happening to CRAs – one of the central parts of the structured finance supply chain. And it is well established that the need for an independent review of credit risk is a significant part of the process. But establishing parameters of risk by a third party in general is just one input in an investor’s decision, and should not be the only focal point. We can’t reasonably expect all CRAs to have the same experience and expertise; CRAs are not interchangeable.

Moreover, the CRA industry has made significant self-imposed improvements. Since 2007 for instance, Standard & Poor’s has invested over $400 million in revamping internal systems, leadership and methods. And with the opportunities for new competition and more available real time public information, firms like S&P will have to continuously improve higher market standards.

Senator Franken’s primary goal is to stop issuers from simply shopping for the highest rating, repeating past practices from the height of the bubble years. But, while understanding the nuts and bolts of history is important in setting a new path for the future, any course that differs from the past does not necessarily make it the right one.

[i] U.S. Matchmaking Board for Credit Raters May Not Solve Conflict