Opinion

Felix Salmon

Why asset managers should ignore credit ratings

By Felix Salmon
May 5, 2009

Jonathan F (a/k/a my boss) wonders whether Goldman’s decision to ignore credit ratings when it comes to bond-investment mandates might not be counterproductive:

The problem with using market prices as a signal for any market action is that it tends to encourage herding by making any market movement self reinforcing. So if a company’s spread widened (or its stock price fell) then investors would react, say by selling its paper, which would then presumably lead to a further credit downgrade. There was a credit agency (it belonged to one of the big ones) that adopted this approach and was blamed for some of the death spirals (or near death spirals) in bank equities in the autumn of 2002 (Commerzbank, etc).

What he’s talking about is a move from the current system, where investors sell bonds which are downgraded to junk, to a new system where investors sell bonds with high credit spreads. Given the choice, the second one seems fairer to me — it means that companies aren’t at the mercy of credit-rating agencies, especially near the crucial triple-B cusp, and it also makes it much easier for the ratings agencies to make that now-fateful downgrade into the Cs.

Taking a bigger-picture view, it can reasonably be said that the ratings agencies, to a good approximation, are basically just lagging indicators for the credit markets anyway. So if you’re going to be exiting certain credits, better you do it sooner, when they gap out, rather than later, when they’re finally downgraded.

It’s also only a minority of corporate credits which really get actively damaged by wider spreads in any case: essentially, it’s the levered companies with a lot of short-term debt needing to be rolled over in the near future. That includes all banks, of course, as well as quasi-banks like GE — but most corporates fund themselves with a mixture of long-term bonds and bank lines of credit, which aren’t nearly as susceptible to market whims.

A move to judging credits based on their spreads rather than their ratings might also help put an end to ratings arbitrage, where companies try to issue debt not where it makes the most sense, necessarily, but rather where they can do so at the lowest cost without damaging their ratings. Essentially the ratings agencies become not a dispassionate observer of how creditworthy the issuer is, so much as a key constituency to be kept in mind when putting any kind of debt deal together. That’s unhealthy, as we saw in the wake of the structured-credit boom. And it should come to an end in the corporate world, too.

But mostly fund managers should stop relying on ratings in any case. They’re both in the business of judging credit: fund managers who outsource that business to a ratings agency are simply not doing their job. And their clients shouldn’t ask that they do so.

Comments
7 comments so far | RSS Comments RSS

The biggest change will occur when regulations are no longer based on holding AAA, though I’m not sure I see an alternative yet. You could argue rather convincingly that part of the reason for the current mess is the high demand for AAA rated securities. If we could find a better way to do that, we may not have seen as many AAA rate junk CDOs.

 

The problem too many investors have is that they simply don’t have the resources to do all the needed credit analysis themselves. That’s why they rely on third parties.

It’s true credit ratings tend to lag, but it’s also true they are much, much less volatile. And that’s a big plus for many fund managers. If you believe market spreads are a better indicator of credit risk tha you also have to believe that credits jump from spec to investment grade and back again in just a few months.

 

Felix, the GSAM proposal is breathtakingly cretinous. The problem is not moving away from ratings (I’ll come back to this), the problem is they are proposing using credit spreads (i.e. market prices) as indicators of riskiness. In other words, the lesson GSAM seem to have learned from the crisis is that markets are more informationally efficient than fundamental analysis. EMH is back! Pure genius.

Do these people know where sub-prime RMBS was trading in, say, 2006? Including on a relative-to-peers basis? I’m told credit spreads on structured paper turned to be a good predictor of true riskiness…

The guy in article says they would segment the market based on market prices and securities that are “the widest 20 percent are the most risky”. This is so stupid, it’s breathtaking.

Now, with regard to ratings. First of all, ratings are not a ‘lagging indicator’ as you say. There are studies out there comparing ratings with market-implied measures: ratings are a more accurate predictor of default over any horizon longer than a year. In other words, the market is only better at picking up near-default (i.e. the bleedingly obvious) with the agencies reluctant to consign companies to the dustbin of history before they really need to. Secondly, corporate and sovereign rating and structured ratings outside of the problematic mortgage & CDO space continue to perform well. However, no doubt things can be improved. The point is that fundamental analysis is still the only one to figure things out: GSAM seem to have discovered they can look up spread on a Bloomberg screen which is all well and good (and amazingly lazy intellectually) but hardly makes them financial Columbuses.

 

> fund managers who outsource that business to a ratings agency are simply not doing their job

On some level, neither are fund managers who outsource to the market as a whole. I don’t think it’s terrible to take account of ratings and spreads if they have information; ideally the fund managers would add extra information, but it’s okay for them to take account of other people’s analyses, too.

 

Problem was not the ratings, it was the regulators who required AAA ratings and then allowed the AAA to be put on anything.

If the regulators now require a spread less than X I\’m sure we can all come up with reasons why that is wrong.

Posted by Mark | Report as abusive
 

Actually, using spreads as a proxy for credit risk would have been an improvement in the case of structured finance AAA’s as well, since those always traded wider than single-credit AAA’s. So if instead of having a regulatory regime which gave a preferential risk-weight treatment to AAA-rated securities, it had given a preferential risk-weight to, say, anything trading Libor-minus, that would have been a very different story. Certainly the structured finance AAA market could not have grown nearly like it did. There are some pro-cyclicality issues here (much like the Mark-To-Market rules debate), but still if you think the market is better at judging this risk than credit rating agencies, or you just don’t like the idea of government-mandated, issuer-funded, heavily-conflicted arbiters of risk, this is probably a net plus.

Posted by Nate | Report as abusive
 

The bigger issue is that ratings of any form (market or funadmental) are used to perpetuate the shell game of taking short term deposits to fund investment in illiquid assets (i.e. the maturity/liquidity mismatch game).

+good point Nate

Posted by thruth | Report as abusive
 

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