Friday, November 13, 2009

Credit Ratings Agencies and how they work

In my opinion, Congress doesn't really understand how credit rating works, fundamentally.
The role of credit raters is to analyze all the information they know about a company and give their best estimate of how safe the security is. They're obligated to try their best to get it right, but risk is nefarious and it's impossible for everyone to always get it right. What makes the ratings companies different from normal security analysis is two things: 1) their estimates are used in Federally-mandated formulae for determining safety of a security, and 2) companies pay raters to have their issues rated, instead of consumers. Ratings are free to consumers.
Thus, ratings are a combination of facts and opinion - in effect, a combination of journalism and opinion.
You cannot hold the raters responsible for unknowingly issuing a bad rating (certainly, if they knowingly misrepresent what they know, that's a different issue, but it has to be an issue of fraud, not judgment - securities analysis is hard, and nobody can or should be certain). If they were held responsible, I'm guessing they'd probably just stop issuing ratings, and instead issue a "facts and opinions" bulletin. While there's a role for that, it's already available through any number of free or inexpensive services; it's far more valuable to the public to have a credit rating as a frame of reference, even when it's wrong.
Far more legitimate is the idea that the raters can't be held to be journalists. Analyzing facts is not the same as reporting them, so it would not be unfair to hold the ratings agencies to the same Reg FD standard that private companies are held to. However, fundamentally, there's societal value in ratings which everyone can consume equally. The fact that consumers don't pay means that in a sense, a company telling a ratings agency something confidential is a way of releasing it, because it'll no longer be confidential. Even if the ratings agency has to keep it confidential, the rating on the issue, available to everyone, will reflect the information.
What WOULD help reform the ratings agency is eliminating the "company pays the rater directly" standard. Much fairer would be a pooling mechanism, the way the FASB (Federal Accounting Standards Board) works - All companies pay into a nondiscretionary pool, which compensates the ratings agencies. You'd have to hammer down how much the ratings agencies are paid (too much and it's wasteful, too little and all the good talent will leave), but this way, the ratings agencies wouldn't have an incentive to appease companies by issuing high ratings because they'll be paid identically for high and low ratings.

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