Rating Agencies: To Regulate or Not?

As perfectly illustrated in today's WSJ, the rating agencies bent over backwards to give questionably high ratings to risky securities like Norma CDO I Ltd., a Merrill Lynch-backed investment vehicle:

In March, Moody's, Standard & Poor's and Fitch Ratings gave Norma their seal of approval. In its report, Fitch cited growing concern about the subprime mortgage business and the high number of borrowers who obtained loans without proof of income. Still, all three rating companies gave slices comprising 75% of the CDO's total value their highest, triple-A rating -- implying they had as little risk as Treasury bonds of the U.S. government.

Of course we know now that that proved to be a disastrous decision by the big three. The agencies maintain that the models they were using to come up with the ratings were based on previous, sound practices.

Ratings companies say their March opinions represented their best read at the time, and called the subprime deterioration unprecedented and unexpectedly rapid. "It's one of the worst performances that we've seen," says Kevin Kendra, a managing director at Fitch. "The world has changed quite drastically -- and our view of the world has changed quite drastically."

Jonathan Laing of Barron's ignores Kendra's plea of ignorance and presents a five-point plan for fixing the rating industry:

• 1. The SEC must encourage more competition by approving more rating agencies, Ratings fees would drop and diversity of opinion would lead to more accurate and timely ratings.
• 2. All ratings agencies should be required to disclose default rates on all classes of securities they've rated. Agencies with bad results should have their SEC approvals yanked temporarily.
• 3. Agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.
• 4. Agencies no longer should have exclusive access to nonpublic information, to even out the playing field.
• 5. Agencies must say "no" to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.

Representing the other side of the argument is this recent working paper from New York Fed economists Adam Ashcraft and Til Schuermann. Taking a broader view, they detail how the sub-prime crisis came about in the first place:

• 1. The products offered to sub-prime borrowers were hard to understand, opening up the door for malfeasance on the part of loan orginators.
• 2. Investment mandates didn't do a good job of distinguishing between corporate and structured ratings, so money managers could reach for yield by buying structured products with the same rating as a corporate bond, but with higher coupons.
• 3. If these money managers didn't conduct good due diligence (as was increasingly the case the more popular sub-prime products became) that reduced the incentives for arrangers like the entities involved in creating Norma to conduct their own robust due diligence. That also meant that arrangers of securitized products could keep the good loans for themselves and securitize the bad loans.
• 4. A lack of due diligence on the part of security creators gave further incentive for some loan originators to practice mortgage fraud.
• 5. These problems were exacerbated by the fact that credit agencies were using poor models to come with their ratings.

So how to fix these cracks in the securitization armor? Ashcraft and Schuermann are not convinced that regulation is the answer:

"the market is already taking steps in the right direction. For example, the credit rating agencies have already responded with greater transparency and have announced significant changes in the rating process. In addition, the demand for structured credit products generally and subprime mortgage securitizations in particular has declined significantly as investors have started to re-assess their own views of the risk in these products. Along these lines, it may be advisable for policymakers to give the market a chance to self-correct."

No matter which side you're one, what are the chances of increased regulation? Back in September, S.E.C. Chairman Chris Cox said the role of rating agencies was being looked into but otherwise everything else has been quite on the regulation front.

(For a take-down of Laing's plan check out Aleph blog.)