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The Way Forward For Credit Ratings

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Long before we were told by the Securities and Exchange Commission that short-sellers and rumor mongers were behind our credit market crisis, blame was being heaped on the ratings agencies. While we've since moved on here in these United States, attention in Europe has largely remained focused on the ratings agencies. The Europeans are proposing that regulators take on oversight responsibility for the agencies, on the dubious assumption that regulators will better be able to determine errors in credit quality assessment than market processes.
But we have a better idea.

For those who believed that agency ratings were akin to Platonic forms--representing permanent metaphysical truths about the quality of a borrower or a credit product--the poor performance of highly rated credit instruments, especially those tied to the subprime mortgage market, comes as a shock. But there weren't many of those subscribing to that faith who were trading debt in the market. We know this because prices on similarly rated credits based on very different asset types--say a triple A rated mortgage backed security and a triple A rated piece of general corporate indebtedness--weren't identical.
Debt issued in riskier categories had lower prices and higher yields than less risky debt, regardless of the rating assigned. This demonstrates that players in this market understood that ratings were relative to the type of underlying debt.
Unfortunately, the divergence in pricing probably was not as great as it should have been. Those risky triple-A's were even riskier than their pricing implied, which is one reason the losses on these instruments far outpace the models of the banks that bought and held them. There are strong indications, however, that these pricing errors were not market failures so much as regulatory failures.
Various regulations--from capital requirements at banks, to restrictions on pension funds investments, to disclosure requirements--created additional demand for highly rated debt built on risky assets. Take, for example, a state pension fund required to invest in only triple-A rated credits. It would naturally be tempted toward the riskier side of the credit market in order to achieve higher returns while operating within its regulatory restrictions. The problem was not that the fund managers didn't understand the products were riskier--pricing made that obvious--but that they decided to engage in regulatory arbitrage, exploiting the gap between a regulator's Platonic view of agency ratings and the reality of ratings.
Over time, such a dynamic becomes irresistible. With other pension fund managers, bank treasurers and corporate financial officers plumping their returns with risky credit products, a conservative investor who avoided this regulatory arbitrage would have found themselves underperforming the market, which is a quick path to unemployment.
The increased demand for risky-yet-highly-rated products would have depressed yields in the market, obscuring the information about risk from pricing. In short, a body of regulations that didn't fit well with market processes wound up distorting those market processes in a disastrous way.
The European proposals to regulate the credit agencies seek to bring the ratings into line with the regulators' preferred Platonic view rather than make the regulations better fit the market. In order to do so, the propose removing information from the market--or at least making it harder to come by. Rating all debt regardless of the assets beneath on the same scale will make it more difficult to make comparisons within asset classes.
What's worse, there's little to suggest that regulators will be able to more properly assess credit risk than the market processes--however flawed--that preceded them.
Fortunately, the very market processes that demonstrate that the regulatory view of agency ratings was mistaken also point to a market-based solution. Instead of relying on ratings for satisfying capital requirements, fund-rule compliance and disclosure, the regulations should be built off actual pricing of instruments in the markets. Here's how a market-pricing regulatory scheme would work: the riskiness of instruments would simply be judged by their yields. Higher yield credit instruments would appear in the riskiest categories while lower yield instruments in the least risky categories. Rather than rely on the wisdom of experts--regulators or ratings agencies--the system would rely on the collective intelligence of markets.
No doubt such a system would be hated by many fund managers, financial officers and banks. They prefer the Basel II methods--which either rely upon their own internal expertise or rating agency expertise--for evaluating credit quality. Regulators too will be loathe to give their rules and rule-making powers. Even ratings agencies would probably resist, as it makes their ratings less important. And we know all to well that it is now fashionable to despise mark-to-market requirements, to which this proposal bears a strong resemblance. But with billions of write-downs and government bailouts, is it too much to ask that the markets be given a chance to better the experts?