Friday, November 21, 2008

"Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings"

David Zetland on Angry Bear offers up a plan to clean up the ratings agency mess:

"I read yet another story on how the credit rating agencies (Standard and Poors, Moodys, Fitch, et al.) failed at their task of rating credit instruments (bonds, derivatives, etc.) to reflect the risk of those instruments.

The credit rating business works like this: Companies that want to issue instruments pay the agencies to rate them (AAA, BBb, etc.) for risk. The companies then sell instruments on the market to buyers who look at the rating when deciding how much to pay. The higher the rating, the higher the price that the companies will get, and the less risk the buyers think they are taking on.

Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings (in exchange for bigger fees, more future business, etc.), but buyers depend on agency ratings.

Unfortunately, buyers cannot pay the agencies. They cannot pay in advance (they are not sure they will buy until AFTER ratings are done), and -- even if they did -- they would suffer from free-riding (if some buyers pay for the rating, other buyers can use that information without paying).

So, how do we fix the system (improving accuracy) while maintaining the current payment relationships? Change incentives in this way:

1. Set a standard fee for rating that depends on the type of instrument, the size of the issue, etc. Such standardization would remove one obvious problem (negotiated fees) while giving agencies an incentive to turn down business that's too complicated to understand.
2. Track the performance of all instruments rated by an agency in a given credit category (e.g., AA-) against all others in that category. Those that underperformed (price fell below the average) are probably riskier than the initial rating indicated, i.e., the agency was overoptimistic. Performance ratings should be weighted by the age of the instrument/rating, the size of the issue, etc.
3. Adjust each agency's fees to equal some fraction of the standard fee based on that agency's performance relative to other agencies, e.g., 80% if ratings are too high (missing hidden risk) or 110% if the ratings are too low (seeing non-existing risk).

Under this system, buyers could observe how accurate agencies are, and companies would have an explicit notion that they are paying for a rating of an agency that's often too optimistic/pessimistic, etc.

Note that this system depends on competition, so it's important to avoid cartels, oligopoly, etc. Even if standard prices are "set" (good place for a regulator), the competition will take place ex-post, when markets "reveal" the quality of the agencies' work.

Also note that #2 alone could do quite a lot to improve matters, but it's nice to link income to performance (#1 and #3).

Bottom Line: We need credit ratings, but we need to punish rating agencies that do a bad job, and the market is the best place for punishment."

I like the attempt. Here's my comment:

"There are two kinds of ratings being used interchangeably here(I'm fudging a bit):
1) Assessing an agreed upon and measurable product from a disinterested viewpoint, e.g., an engine
2) Assessing with more of a value judgment implied, e.g., a movie
If you read this quote from an interview of Eliot Janeway in the IRA, you'll see a transition:

http://us1.institutionalriskanal...pub/IRAMain.asp

""The IRA: The rating agency monopoly up to this crisis could certainly be viewed as a form of legalized extortion. There was no choice for a global issuer but to go to Moody's or S&P.

Janeway: Yes, but even so the job of the rating agencies until as little as a decade ago was to evaluate cash flows. Then came the CDO.

The IRA: Yes but Moody's and S&P were not explicitly paid to notch CDOs each month. They were paid in the primary market effectively acting as an adviser - and sharing in commissions. But there was no "issuer pay" model explicit in the CDO budget for following these deals in the secondary market."
Now, I'm taking liberties to make a point, which is that with this kind of possible conflict of interest, only Type 1 rating can work.
In other words, what credit agencies can rate safely are agreed upon standards, in which all that they are doing is presenting the analysis from outside of the company being rated. Investments like CDO's were more like Type 2, and simply weren't advisable at all to be rated by these agencies.
So, for me, although I would force the agencies to at least compete in pricing, their only use so constituted is to look over boilerplate figures and rate them. Of course, they are not responsible for the figures. The companies are.
The alternative is for investors to set up ratings agencies, which, if confined to basic analysis, I'm not so sure couldn't break through the entry problems. But how the hell do I know.
"

Here's his reply:

@Don: Good point, but "my" system would reduce the upward, subjective bias (your #2) because agencies would LOSE money when they were over-optimistic.

"Don

In my "model" they are all equally good (or bad) because they choose to be so -- they follow each other as "about as good as the other two" is plenty good enough.

I think that, if investors are rational, the entry cost of becoming a credit rater should be huge. My complaint about them is that they gave AAA to assets which had not stood the test of time. Obviously, I would pay no attention to a credit ratings agency which did not have a decades long record. I don't think I'm the only one. I'd guess that a new agency would have to work for years or decades before anyone cared what they said and only then could begin to have positive revenues let alone profits.

The fees are, apparently, not really fees, because the agencies rate bonds even if they are not paid. That is claimed in the article I linked to as
this in "damn 'this'" upthread. It appears that 98% of firms pay for their bonds to be rated even though the credit rating agencies rate the bonds of the remaining 2%. The fees are, in any case, a tiny part of the cost of capital. I'm going to post this now then get the reference.
"

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