"attention has turned to the structure and performance of the bond rating industry"

Here's a post from Jerome Fons about Credit Ratings Agencies, which I found by looking at the web page for the PBS show NOW, which last night focused on credit ratings agencies:

" As subprime mortgage losses cascade throughout the global financial system, attention has turned to the structure and performance of the bond rating industry. Faulty ratings on securities backed by subprime mortgages are believed responsible for billions of dollars in losses. This White Paper argues that any such faulty ratings are due in part to conflicts inherent in the issuer-pays rating agency business model. Such conflicts, when combined with existing structured finance practices, have led to widespread rating shopping. Efforts to increase competition among rating agencies may exacerbate the problem unless fundamental changes occur in the structured finance area, particularly in attitudes toward unsolicited ratings."

Okay. The problems are Conflict Of Interest because:
1) The companies rated pay for the rating ( This just is a serious problem )
2) Shopping around by companies for a better rating ( Remember, there are at least three big ones ) NB: S. Waldmann believes that this isn't a big issue because of ratings collusion, which is a serious problem in and of itself

These are enough for me to conclude that, as I said in another post, the only things that could even have a chance of being rated fairly are clearly defined and analyzable data or products, where all that's being paid for is a third party assurance. Otherwise, to the extent that it involves more analysis and judgment, it's a disaster waiting to happen, which it did with CDOs.

"Today’s credit rating industry traces its roots to the 19th century commercial credit bureaus, whose simple grading systems helped facilitate trading among merchants. At the same time, the birth of the US corporate bond market was underway as financing for the bulging nation’s railroads was desperately needed. Large sums were required and the expected horizon of borrowing was many years. Because banks alone could not meet these needs, bonds became the preferred financing vehicle for the many, initially quite separate, railroad companies dotting the landscape of the late 1800s. Seeing a need for information to assist potential buyers of railroad bonds, several enterprises began marketing “manuals” of financial data and other statistics. Poor’s manuals were soon joined by John Moody’s railroad and industrial manual. This was a difficult business because the barriers to entry were fairly low and high volumes were necessary to cover printing and distribution costs. Moreover, demand was highly dependent upon market conditions, which tended to be quite volatile around the start of the 20th century."

So, how did this change ( Notice the low entry fee ):

"After losing his manual business following the panic of 1907, John Moody decided to implement an idea suggested to him by an associate. He created a system that graded bonds according to their investment quality. The 1909 publication of Moody’s Analyses of Railroad Investments thus marked the beginning of the bond rating industry. In the following decades, Standard Statistics (later merged with Poor’s) and subsequently, Fitch, joined the ratings fray. By convention, bond ratings are opinions of relative credit quality.1 These are expressed using comparable, simple rating systems."

These opinions are the problem. Are they constrained enough to be credible?

"Most rating agencies rely on a rating system expressed, from highest to lowest, as AAA, AA, A, BBB, BB, B, CCC, CC, C and D, while Moody’s has continued to use its Aaa, Aa, A, Baa, Ba, B, Caa, Ca and C system. As the acceptance of ratings grew, so did their application. The large rating agencies today assign credit ratings to corporate bonds, commercial paper, preferred stock, syndicated bank loans, sovereign nations, municipal obligations, infrastructure projects, structured finance transactions, bank deposits and mutual funds. Managing Conflicts Prior to 1970, rating agencies did not accept payment from rated bond issuers.2 Instead, they financed their rating operations through manual sales and investment advisory services. Rating agencies were well aware of the conflicts of interest posed by the “issuer-pays” business model. By accepting payment from an issuer, a rating agency sacrifices its independence. It has a vested interest in the success of a bond offering and in the welfare of the issuer."

So, earlier, they had not been paid by the companies. Also, their ratings had managed to survive for years, giving the system the appearance of constraint and reliability.

"Despite this conflict, the issuer-pays model now dominates the industry. Market features and business practices have evolved to help offset this conflict of interest. These safeguards, however, do not eliminate the conflict. Reputation Risk First and foremost, the credibility (and therefore the value) of a rating presumably derives from the reputation of the issuing agency. Any agency suspected of selling high ratings would, in a free market, see its business deteriorate as such ratings would not influence bond pricing decisions. The market would discount or ignore ratings of agencies whose reputation is tarnished. It is argued that building a stellar reputation requires a long-term horizon and view. Yet managers of publicly owned rating agencies are subject to intense short-term pressure to demonstrate earnings growth. It takes tremendous discipline to turn away business, particularly when competitors are building market share. Recent rating mistakes, while undoubtedly harming reputations, have not materially hurt the rating agencies.3 On the contrary, rating mistakes have in many cases been accompanied by an increase in the demand for rating services. One could conclude that reputation risk is not an important deterrent to poor ratings. Separating Analysis from Business Pressures Independent, non-conflicted ratings do not take into account revenue implications for the rating agency. A popular practice that helps meet this objective is the rating committee. More specifically, a rating committee where those with business objectives have little, or at best, equal voting rights, can help resist some of the pressure exerted by an issuer. Even better would be a rating committee in which such individuals play no role whatsoever. Also, a larger committee may (though not necessarily) have a smaller stake in the rating outcome, further improving rating independence."

See, to me, this is what happened:
1) The companies rated started paying for the ratings
2) They were trading on years of credibility where this conflict of interest didn't occur
3) They started being asked to rate products that were not easily and clearly analyzable, moving from a rating that simply determines a fact to a rating that issues a de facto assessment and recommendation

Solutions could be:
1) A rating committee ( To be comprised with as many people who do not profit from the rating as possible )

"Publicly available rating methodologies, providing sufficient detail to guide a layman towards plausible rating outcomes, are one of the most important tools to counteract the issuer-pays conflict. A transparent methodology makes it difficult to justify a higher-than-warranted rating outcome. Transparency in the financial situation of the rated issuer or obligation is also important in managing the conflict. For one thing, an issuer with publicly available financial data is open to scrutiny by a wide range of market participants. It is easier for investors to apply rating criteria and compare with published ratings when there is financial transparency. Moreover, as a defense against “rating shopping,” any rating agency can (in principle) assign a rating to an issuer with transparent financial reports.4 As discussed below, many structured finance transactions fail this transparency test."

This follows from my requirement that the product rated by clearly analyzable and defined, and merely be asking for a third party assurance.

"A related characteristic, objectivity, can provide a defense against conflicted ratings. What is typically meant by objectivity is that a rating methodology is based on non-subjective, observable, criteria. Objective ratings are not subject to the whims of any particular analyst or rating committee. Complications can arise, however, when trying to balance an objective methodology against the desire to be “forward looking,” or able to include new or unanticipated factors into a rating. Analysts will often argue that they need to be flexible in applying a methodology. So long as the arguments for deviating from a published methodology in a given situation are clear (and publicly available), this complication can be managed."

Same point as above.

"A large rating agency is less likely to suffer financially by assigning low ratings to a given issuer. Since no single issuer can materially affect the revenue of the rating agency, the temptation to sell a high rating is more easily offset by reputation concerns. Consequently, a larger rating agency is more likely to have the financial resources, and therefore discipline, to stand up to any individual rated issuer."

My problem is the entry fee is impossible to overcome then, essentially granting a cartel. That makes my point about merely being a third party assessment essential.

"In addition to these defenses, various corporate governance safeguards must also be in place. It is generally agreed that a large, diversified corporate parent should not own a rating agency. Corporate pressures may cause the agency to “lowball” ratings for competitors of its sister companies. If the rating agency is publicly owned, the board of directors (often with their own corporate affiliations) must not participate in rating decisions. One could argue that the need to meet financial targets of any kind places undue pressure on the quality of ratings under the issuer-pays framework."

This seems quite clear. The ratings agencies need to be independent entities. Payment issues could be addressed separately.

"Because the rating industry tends to be dominated by a few large firms, many observers assume that greater competition can improve the quality of ratings. One of the goals of the Credit Rating Agency Reform Act of 2006 is to open the NRSRO recognition process to a wider array of firms.5 Unfortunately, increased competition can instead lead to rating shopping and a race to the bottom, in terms of ratings quality. "

It's a bit counter-intuitive. First they needed to be large, now they need to be few, with no more competition.

"It is useful to examine briefly what is meant by ratings quality. Rating quality is difficult to quantify. Most market observers equate rating quality with rating accuracy. Although there are no official measures in place for determining rating accuracy, the basic idea is that the more accurate a rating system, the better it discriminates ex ante between those issuers (or obligations) that default and those that do not.6 Because defaults tend to be somewhat rare, establishing a rating system’s accuracy can be difficult, particularly if one focuses on a single industry or region. Many users of ratings are focused not on the accuracy of ratings, but rather on subjective features, such as speed of execution, responsiveness to inquiries, or other aspects of service.7 In the absence of clearly articulated and observable rating system objectives, competition among rating agencies often occurs along these dimensions."

This has to change. There has to be a way to assess performance among competitors, especially in a small group, otherwise, they'll be an actual cartel. If the entry fee is so high, then you have to allow a method for at least price competition, and without a means of assessing performance, how could one do that? Strangely, Ratings Agencies can't be rated. What do they sell then, if it can't be compared? It sounds like optimism.

"The target market for bond ratings most accurately falls under the label “institutional buy-side.” That is, today’s rating agencies are organized to cater to large fund managers and other investor-agents. These well-funded participants hold tremendous sway with banks, broker dealers and bond-issuing companies. Many asset managers are themselves governed by ratings-based investment guidelines. These guidelines, in turn, lead many of these professionals to “game” ratings, rather than view them as helpful investment signals."

That's right. Optimism.

"Consider the rating needs of a typical bond fund manager. When deciding whether or not to buy a particular bond, the manager wants an accurate, independent opinion of the bond’s credit risk. Upon purchasing the bond, however, the manager’s interest in an accurate rating deteriorates. In particular, the manager does not want to see the bond’s rating downgraded. In addition to causing a possible decline in price and subsequent portfolio losses, a downgrade may actually force the manager to sell the bond (due to the aforementioned guidelines), even if he or she is disposed to keep it. In other words, a rating agency focused on pleasing fund managers will not necessarily provide a product that protects investors."

That's because they sell optimism.

"This imparts a monopoly status to an established language. Competition – that might arise from a parallel language – if anything, wastes resources through the need to employ interpreters and duplicate documents. Ratings are a type of language. They too gain currency when widely “spoken” and understood. When discussing the attributes of a bond, traders and investors prefer to speak in one rating language. They want to be sure, for example, when told that a bond is rated BBB, it is of a known credit quality. Clarifying that the BBB is from XYZ rating agency often simply confuses the matter.9 Consequently, any emerging, competing risk language will face much resistance until it reaches a critical mass of users. Like a language, a rating system gains currency when both coverage and distribution are broad. Wide coverage – across obligations, issuers, sectors and regions – facilitates investment comparisons. Wide distribution also increases the chances that users will prefer one rating system to another. Unfortunately, the high costs of achieving broad coverage and wide distribution form a barrier to entry. Most financial news and data providers allocate space for just one or two rating systems. Large investors and others buy feeds from the major rating agencies and must configure their databases and display systems to handle each rating system. Issuers generally do not enjoy meeting with rating agencies. Beyond enduring uncomfortable questions, they must prepare presentations and allocate scarce time and personnel for meetings. They do not want to meet with 10 rating agencies. Nor do they want to buy the services of 10 rating agencies. In other words, there is a network effect at the rating industry level and smaller network effect with respect to an individual rating agency. In order for a competing system to displace the established rating paradigm, it must entice a critical mass of users. Such early adopters must be willing to bear costs without yet benefiting from the network effect. And in order for a new rating agency to become successful, it must achieve broad coverage and distribution at a substantial financial risk. As illustrated below, under certain conditions, competition between rating agencies leads to rating shopping and thus to sub-par rating opinions."

Again, to hell with entry fee and competition. Won't work. To expensive to learn to speak this language.

"The recent failure of rating agencies to signal in a timely and accurate fashion the condition of many securities backed by subprime housing loans can be traced to weaknesses (or outright failures) in the protections against conflicts of interest cited above. It is instructive to describe first the rating process for structured transactions."

This ought to be fun.

"The structured finance industry arose as a partnership between Wall Street and the rating industry. In principle, modern structured transactions can trace their lineage to practices used to package the obligations of the US government sponsored enterprises (GSEs), such as those of Fannie Mae and Freddie Mac. These organizations issue securities backed by so-called “conforming” loans used to finance home purchases. Even though the underlying loans are subject to credit risk, the GSEs guarantee the securities backed by risky loans. The principal risks, therefore, stem from changes in interest rates and the somewhat related risk of prepayment."

Don't tell the blame Freddie/Fannie crowd this. You know, I don't like government guarantees, so, truly speaking, this is part of the problem. Not so much in itself, but as a precedent.

"What Wall Street brought to the table was the repackaging of GSE securities into bonds that represented various bets on the direction of these risks."

This is what I keep telling Derivative Dribble, but he's having none of it.

"Because the GSEs only buy so-called conforming loans, there appeared an opportunity to issue securities backed by non-conforming loans: those with balances greater than the GSE limits as well as those to borrowers of less than stellar credit standing."

Help me understand how this is not inherently risky, and meant to push the envelope.

"To issue these, a banker or arranger creates a bankruptcy-remote Special Purpose Vehicle (SPV) whose function is to buy a pool of loans and issue securities to finance the purchase of the pool.10 The obligations of the SPV are tranched in such away as to insure that any losses (from delinquent and foreclosed loans) accrue first to the lowest tranche (or security class), and then to the next higher tranche, and so forth. In order to assign a rating to the highest (or any other) tranche, typical practice is to model the loss distribution of the entire loan pool. The objective is to calculate the expected loss for the tranche and match that loss to historical loss rates observed in the corporate bond market. Consequently, a structured finance rating committee for a new issuance does not vote on a rating, per se, but rather on the amount of support (subordinated to the rated tranche) needed to achieve the desired expected loss rate."

Okay. But realize, there's no margin for error here. They're picking the lowest figure that they can conceive of.

"There are a number of ways to model expected pool losses for residential mortgage-backed securities. Most are designed to build a certain amount of leeway into the assigned rating. Common practice is to replicate a severe down in the housing market through statistical methods. Unfortunately for the modelers, outside of the Great Depression, there have been few instances of a widespread decline in home prices and little historical experience with subprime borrowers. Other asset types have been used as underlying collateral for structured transactions. The most common are based on pools of automobile loans, credit card receivables, commercial mortgage loans and corporate bonds. Securitization techniques have also been applied to the tranches of existing securitizations and to pools of derivative securities. "

This boggles the mind. There's not sufficient data. What the hell, let's pretend that houses are cars, corporate bonds, whatever. This can't be explained as anything but a blatant mistake. I'm sorry to be harsh, but it's wishful thinking 101.

"Somewhat unique to the structured finance market is the opacity of rated securities. In certain situations, the details of the underlying asset pool and often the structure of the transaction are not publicly available for external scrutiny."

Opacity= We can't determine their price ( and have no data for their risk ). Makes sense to me, especially with other people's money.

"And unless the banker/originator brings a transaction to a rating agency for evaluation, the agency will generally not have enough information to assign it a rating. The role of rating agencies is particularly important to the structured finance process. Investors rely on agency ratings when making purchase decisions because of the opacity described above. Moreover, the tools to analyze credit risk, even with transparent assets, are beyond the grasp of many investors. Rating methods are quite technical, often relying on advanced statistical techniques. Documentation supporting a transaction can be equally daunting, reading more like a legal brief than helpful financial guidance. In turn, a solid understanding of how to value structured securities remains elusive. No one “model” dominates pricing practices in structured finance. Instead, there are literally dozens to choose from. The business of rating structured finance securities is highly competitive. For one thing, the fees (and corresponding margins) tend to be high relative to other product lines."

I'm sorry. Here's where I claiming that there was Fraud, Negligence, and Fiduciary Mismanagement. Plainly. Or stupidity not seen since...the S & L Debacle, interestingly.

"Structured finance is perhaps the largest single product line for the major rating agencies, representing 40% or more of total revenues. Moreover, growth in structured finance helped fuel high price/earnings multiples for rating agency shares. So there is intense pressure for each agency to see its structured finance practice thrive. In addition to being profitable for rating agencies, structured finance is very profitable for the arranging banks. Consequently, the incentive to see a transaction close is strong. This has led rating agencies to compete on standards of credit support. The rating agency most willing to assign a low level of support to a given transaction is most likely to receive the mandate to rate it. The result is a situation in which rating shopping dominates the structured finance business.14 Reputation risk is in effect traded for short-term financial gain. Bankers can wield tremendous power and play the rating agencies off of one another.15 They are able to do this because many investors see the ratings of Moody’s, S&P and Fitch as interchangeable. Consequently, many investors will purchase a security with ratings from two (or sometimes just one) of the three major agencies. Support levels migrate to the lowest possible values as agencies maneuver to maintain market share. The agency with the highest support level on a given transaction will lose the deal and, over time, its structured finance business. This situation was sustainable in the subprime area so long as pool losses remained subdued. Low support levels (which offer minimal protection to senior securities) seemed sufficient in an atmosphere of easy money and rising home prices. But when losses began to materialize, ratings began to fall, and investor losses surfaced."

This is what I claimed earlier. They relied on their reputation to delve into realms of rating that they were not competent to get into. Their ratings were used to give low risk validity to incredibly risky products.

"Certain market observers point to the use of ratings in regulation as a contributing factor to rating shopping. Because many regulations stipulate minimum rating levels without referencing a specific rating agency, such use contributes to the “commoditization” of ratings. When the SEC, the NAIC or a banking regulator officially recognizes a rating agency, its ratings assume a quasi-official status. One reason this occurs is because many investment professionals simply do not place importance on a rating opinion as long as it meets a regulatory (or institutionally approved) minimum. Most investment managers try to maximize return subject to a specified risk level. In the fixed income universe, ratings are the language used to establish maximum allowable risk levels and are often seen as a constraint. There is in principle a link between ratings and expected return. But investment managers add value through independent research and finding opportunities regardless of the published rating. Official status is thought to be a major contributor to demand for an agency’s ratings. Yet it is extremely difficult to estimate the benefits from official recognition. What is clear is that such recognition is highly sought after by new entrants. Finally, regulators have indicated a bias against unsolicited ratings. In fact, unsolicited ratings provide an opening for new competitors – sometimes the only opening – and form an important defense against rating shopping. As discussed below, when an issuer or its banker cannot suppress an unwanted rating opinion, the incentive to “shop” rating agencies is reduced."

Great. The counter-intuitive economics continues. Regulation makes it worse. They add a patina of respect to whatever these agencies do.

"Alternative Business Models
Given the conflicts inherent in the issuer-pays arrangement, it is worth considering alternative business models. We describe two of these here.'

Sarcasm?

"Mutual ownership, once common in the insurance industry and still widely used by credit unions, can offer an alternative means to garner the resources necessary to compete on a global scale. Unlike public ownership, a mutual organization operates for the benefit of its members. Members supply capital and receive shares in the mutual. As owners, they also share in any profits accruing to the enterprise. Such co-ops offer myriad benefits to their owner-customers, particularly in a non-profit setting. A mutually owned rating agency would have as shareholders commercial banks, investment banks, mutual funds and other institutional investors. One need only look at the client list of any large rating agency to identify potential candidates. Unlike the shareholders of many mutual organizations, these are large, sophisticated entities. A mutual rating agency would not need to charge issuers for ratings. Its shareholder/customers would pay for access to ratings and any affiliated commentary. Access to ratings themselves would be free to all, but the costs would be borne chiefly by the shareholders."

You get the point. A mutually owned agency.

"The power to suppress an unwanted rating opinion is at the heart of the rating shopping problem in structured finance. There must be a shift in the balance of power if rating shopping is to be contained. Specifically, any stigma associated with unsolicited ratings must be banished and biases in regulation eliminated. For example, section 3.9 of the International Organization of Securities Commissions (IOSCO) Code of Conduct Fundamentals for Credit Rating Agencies (CRAs) states: For each rating, the CRA should disclose whether the issuer participated in the rating process. Each rating not initiated at the request of the issuer should be identified as such. The CRA should also disclose its policies and procedures regarding unsolicited ratings. The implication is that unsolicited ratings are necessarily inferior to those solicited and paid for by the issuer. Paragraph 108 of the Basel Committee on Bank Supervision’s International Convergence of Capital Measurement and Capital Standards (Basel II) raises further concerns when discussing External Credit Assessment Institutions (ECAIs): As a general rule, banks should use solicited ratings from eligible ECAIs. National supervisory authorities may, however, allow banks to use unsolicited ratings in the same way as solicited ratings. However, there may be the potential for ECAIs to use unsolicited ratings to put pressure on entities to obtain solicited ratings. Such behaviour, when identified, should cause supervisors to consider whether to continue recognising such ECAIs as eligible for capital adequacy purposes. Although ostensibly addressing potentially anticompetitive practices, intense pressure from European corporate issuers was likely the motivation for this guidance.18 Competitive forces will not improve the quality of ratings without the ability to offer an unsolicited opinion. For their part, rating agencies must not use unsolicited ratings in anticompetitive ways. Anticompetitive behavior might occur, for example, if a major rating agency were to enter a new market and “dump” free ratings in order to drive out potential new entrants."

Okay. The second option is what we have now. However, he advocates allowing unsolicited ratings as a way to encourage competition by lowering the entry fee.

"Regulatory authorities must insist that future structured finance transactions be sufficiently transparent in their structure and in the details of the underlying collateral that any rating agency may offer a credible opinion, whether it was selected by the originator or not. Rating agencies must publish and abide by transparent methodologies for rating structured securities. They must provide these for every asset class and each must meet certain minimum criteria. The overriding principle is that an outside party following the methodology should be able to conclude to the rating (or, more specifically, support level) reached by a rating committee. At most, any deviation would be minor. If the rating methodology is expressed in terms of a model, that model should be available to all (for free) so that any sufficiently competent user can replicate the rating/support outcome. In those instances where a rating agency deviates from its methodology, it must explain why. For existing transactions, there should be adequate public disclosure of the underlying asset pool performance and sufficient disclosure of the parameters and thresholds that might lead to a rating change. This assumes that transactions are indeed monitored once completed. It does not mean, however, that rating agencies should operate in a totally mechanical fashion. There must be room for human judgment and effort should be made to encourage forward-looking criteria. But the emphasis should, first and foremost, be on transparency. Even if market forces do not render them extinct going forward, the rating of complex structures should be avoided or prohibited. Complexity is attractive to rating agencies because fees can be much higher than those for simpler, generic securitizations. Complexity, however, is anathema to transparency, and thus opens the gate to rating shopping. These suggestions are meant to assure the survival of the rating industry, not to drive it into poverty. Unless the incentive to shop ratings is removed, the industry risks obsolescence. Alternative risk measures will emerge and gain currency. While this may happen on its own accord, better ratings may forestall such an outcome. "

This is validation of my idea that the ratings must evaluate clearly defined and analyzable products, open to clear evaluation as to their objectivity and performance.

"Conclusion
Rating agencies perform a valuable social service. Their opinions can help improve the efficiency of capital markets. Conflicts inherent in the issuer-pays business model have instead contributed to faulty ratings for many structured finance securities. Increased competition alone will not fix the problem. Rather, fundamental changes must be made in the way structured finance securities are created and marketed. Increased transparency in the structure and performance of individual transactions, along with increased transparency in rating agency methodologies, will allow investors and rating agency competitors to assure standards are being met. In order for competition to succeed, biases against unsolicited ratings must fall."

Bottom line:
1) Ratings must be confined to products which are capable of being evaluated
2) Competition must increase

I've outlined the solutions as we've gone along.