Accurate Credit Ratings

Sen. Franken is asking the SEC to set up a body to govern Credit Ratings Agencies and assign rating work to them on a rotating basis. Now, if any part of that makes sense to you, you probably already know where I’m going. For those of you who don’t, let’s recap:

During the credit boom of 2002-2007, banks and brokerages that issued credit securities (or debt, including mortgages on commercial properties and asset backed securities based on home loans and car loans as well as unsecured debts like credit cards) learned how to game the system first by selecting which rating agency they would use based on which one would give them the highest rating. When that became difficult, they learned how to ‘game’ the models the agencies used to rate the securities. In effect, they manipulated the structure of the security to come in high on certain features that the agencies models focused on. If you’re thinking this sounds like a loan officer browbeating an appraiser to arrive at a pre-determined value for a home, you’re a lot smarter than you think.

When the world came crashing down in late 2007 and well into 2008, the folks who had bought all these credits as investments suddenly learned that the AAA security they bought was actually a low B or C credit, very much below investment grade. This incited a panic among fixed income investors because now they couldn’t trust the ratings agencies. When that happened, the entire market froze… they tend to do that when there is a panic. The banks didn’t stop issuing because they ran out of raw material for the securities, they stopped issuing because no one wanted to buy those securities since they didn’t trust the rating on them.

All that was to be expected when the party came to an end. However, the debt markets are only now beginning to pick up and once again, we’re seeing the banks up to their same old tricks. Rather than move forward to the next inevitable bust, Sen. Franken has the idea to stop allowing banks to ‘ratings shop’ and instead force them to come to the SEC and have a rater assigned. Instantly, that would remove pressure from the raters and allow them to come up with grades that investors can have some confidence in.

This isn’t unprecedented as anyone who has recently purchased a home knows. Loan Originators can no longer select appraisers, they have to use an Appraisal Management Company which in turn sends out a bid to their pool of appraisers for the work of valuing a home. The originators are strictly prohibited from contacting the appraiser directly, all communication must go through the AMC. This allows investors (like me) to know that the originator is not manipulating the appraiser to arrive at a predetermined value.

Given that this is in place in one part of the credit market, why the hell is it such a conceptual leap to apply it to the debt that’s sold to pension funds? Because the issuers (the big banks) don’t like being told they can’t game the system.

A lobbyist for the industry, Roel Campos of Locke Lord, was on Bloomberg earlier today. He said (and I’m paraphrasing since it was a live feed) having a government body assign a firm to rate a security would make people think the government stands behind the rating. He went on to say it’ll destroy the market.

Now, I love a PR flack as much as the next guy but this is some grade AAA bullshit worthy of some kind of award. For one thing, the market destroyed itself and is only recently slowly and painfully rebuilding. What we’re doing now is trying to prevent a breakdown from happening again. As for the people assuming the government stands behind the rating, it’s not like we’re talking about innocents who don’t know a debenture from a debit card. These are professional investors and if the rating is from Fitch, for example, they’ll know it’s from them and not Uncle Sam. Campos, it’s worth mentioning, was one of the yes votes on the SEC when that august body decided to allow the banks to manage their own leverage levels which allowed them to load up on debt like a freshman college student. It was a really stupid move. I’m pointing it out not because I think Campos is stupid (quite the contrary), but because his record with regard to regulating the big banks is spotty.

This really boils down to a simple question… should the banks issuing the securities have a say in who rates those securities? Put another way, wouldn’t it be better if the ratings agencies that issue the ratings on the securities be independent of (and insulated from) the banks? The answer is no and yes, respectively. Until we fully restore confidence in the integrity of the ratings, at best we’re going to have a much diminished market for credit. At worst, it’ll just be a matter of time before the next crushing crisis.

This entry was posted in Business. Bookmark the permalink.

Comments are closed.