Approximately one-third of the U.S. bond market is accounted for by structured deals – bonds backed by income streams from assets such as mortgages, auto loans and credit card payments – that are extremely complex in nature and difficult to evaluate in terms of credit-worthiness. When new bond offerings of this kind are launched, investors are especially dependent on the ratings provided by one or more of the major credit ratings agencies – Fitch, Moody’s, S&P and (increasingly) the Toronto-based DPRS – that supposedly patrol this market to provide relevant ratings information to potential investors.
As a consequence of incompetence and corruption, these ratings companies failed to perform their duties during the run-up to the financial crisis of September 2008, and thus played a significant role in luring investors into excessively high risk holdings. Of the triple-A rated mortgage bonds issued in 2004, only 3 per cent are now rated ‘junk’. Of the triple-A rated mortgage bonds issued in 2005, 64 per cent are now rated ‘junk’, of those issued in 2006 and 2007, almost 90 per cent are now rated junk. The numbers speak for themselves.
As always, in such circumstances, one should follow the money in seeking an answer as to why this calamitous decline in ratings quality occurred. As the complexity of mortgage, auto, and credit-based bonds increased through the early noughties, credit ratings failure was a promise awaiting fruition. In large part, the problem lay in the post-1970 nature of the market itself.
Prior to 1970, credit ratings on new bond issues were paid for by potential investors, naturally looking to the credit raters for honest evaluations. This arrangement came under criticism, because it allowed small investors to free-ride on major investors, who carried the entire cost of the ratings investment. This rendered it uneconomic to rate some smaller bond issues. In consequence, bond issuers began t0 pay for their own ratings, thereby opening up the prospect that a bond ratings will be as high as money can buy.
The ratings companies, competing fiercely among themselves, can ill afford to secure a reputation for tough grading, just as academic faculty seeking merit pay increases find it difficult to avoid grade inflation when student evaluations influence the size of said merit payments. Just as poor quality students shop around among faculty and enroll for classes instructed by loose graders, so junk bond issuers shop around among ratings companies to secure triple-A grades for their issues.
One might think that reputational constraints would limit the extent to which the ratings companies can debase their assessments without losing market credibility. Unfortunately, this is not the case, largely because new entry into the ratings industry is restricted by bank capital regulations that rely on the ratings of the recognized bond rating companies. So shopping around among the rating companies has become a major method whereby complex bond issues are protected from the sunlight of accurate assessments.
How might this failure of government and private markets be ameliorated without imposing a significant competitive handicap on the U.S. financial markets? In my judgment, the following measures are worthy of consideration.
First, require all would-be bond issuers to place in the public domain all information that they provide to any ratings company concerning their bond issues. This would allow concerned potential investors to patrol the bond issues for themselves.
Second, remove all ratings requirements from banks that invest in bond issues, but require all banks fully to disclose any ratings that they have used as the basis for their investments. This will open up the ratings industry to new entry and increase competitive pressures on incompetent and corrupt raters.
Third, require any bond issuer who seeks bond ratings for his bonds to make full disclosure of any contact with a ratings company, whether or not a bond rating is secured. Further require bond issuers to disclose publicly every rating that they receive, whether one or more. This will significantly reduce the race to the bottom, lowest common denominator ratings shopping that still characterizes this market.
Fourth, require all ratings companies to maintain a public register of all changes in bond ratings that they make over the lifetime of a bond issue. This will inform rational investors of the trust that they can place in that company’s ratings.
Hat Tip Aaron Lucchetti and Serena Ng, ‘Ratings Shopping Lives On As Congress Debates a Fix’, The Wall Street Journal, May 24, 2010