Does America need to support credit rating agency competition?
The implosion of the global credit bubble in 2007 and 2008 laid bare the inflated credit ratings on several trillion dollars of US structured finance products. These inflated ratings were a big contributor to the creation of a global credit bubble. In many cases these AAA securities suffered major principal losses as the underlying mortgages defaulted at rates that had never been modeled or even imagined. Bill Gross of Pimco famously said in 2007:
“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels and a ‘tramp stamp,'” Gross said in his monthly commentary posted on Pimco’s website today. “Many of these good looking girls are not high-class assets worth 100 cents on the dollar.”
Following the global financial collapse, the agencies that assigned these ratings were lashed in Congressional hearings and saddled with more regulation via Dodd-Frank. Foreign governments kicked their regulatory engines into gear and begin crafting new frameworks for regulation of raters.
In the European sovereign debt crisis of 2010 the major global raters (Fitch, Moody’s and Standard & Poor’s) once again distorted markets by waiting too late to downgrade sovereign ratings and did it as the EU and ECB were trying to craft a sovereign rescue. Sovereign debt prices swung widely as raters passed out multi-notch rating changes. Regulators around the world were ready to take raters to the gibbet again. This increased oversight has happened at varied speeds as nations account for local market and regulatory frameworks. But global efforts have been accelerating.
The United Nations held a day of discussion about the oversight of credit raters by member countries. This follows ongoing efforts by the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB) to coordinate and standardize oversight of these powerful global firms.
The US has been leading reform efforts since 2002. Raters had kept Enron and Worldcom at investment grade almost up to the time they filed for bankruptcy in 2001, which triggered Congressional calls for review of these unregulated market players. Years of U.S. review led to the Credit Rating Agency Reform Act of 2006, which was just being implemented as credit markets blew up in 2007.
The U.S. and E.U., through ESMA, now have inspection regimes for raters and methods for attempting to monitor conflicts of interest. But these efforts are still in the early stages of development.
The recurring theme through the U.N. discussions was the need for increased competition among raters. Merli Baroudi, Director and Chief Credit Officer of Finance and Credit Risk of the World Bank spoke to the need for more diversity among rating opinions and methodologies not just a greater number of raters. This is a key problem among raters as many market participants note that they often mirror each other on ratings. Correcting this involves a number of hurdles.
First credit analysis is an arcane speciality. Students learn to read balance sheets and cash flow statements in college and business school but this is the minimum level of skill necessary to do good credit analysis. Rating agencies spend most of their budgets on credit professionals salaries. Once trained in a rating agency the best analysts are often hired away by buyside firms, investment banks and insurance companies to monitor their credit risk. Depending on where we are in the credit cycle analysts are great demand.
Governments, especially in the United States, should consider establishing a credit analyst training institute to increase the number of trained credit professionals. This could be done in partnership with a professional association like the CFA Institute that has experience training and testing financial professionals. An increased flow of analysts would make establishing new credit rating agencies more affordable. This would also have the broader effect of creating a growing supply of highly trained credit analysts that could keep pace with ever increasing debt issuance. More debt outstanding requires more credit analysis.
Second, if the U.S. is really serious about developing more competition for raters we should consider seed funding new agencies through a competitive process. Establishing a new rater depends on either raising capital for a very risky venture or quickly developing cash flow sufficient to sustain the salaries and expenses of the firm. The seed money could come from the SEC budget, special appropriations from Congress or debt market user fees. Many of these new firms are likely to fail but if one firm every several years was able to get market traction and expand competition would increase for raters. I can think of several established firms already that make great candidates for this idea, like Creditsights. If we expect small firms to take on the mega raters we should provide monetary support. How is this legitimate? Ratings are a public good and contribute to orderly, liquid credit markets which is the foundation of capital creation and economic growth. Having a wealth of credit opinions helps create and sustain competition for capital.
The three major credit rating firms have had an oligopolistic hold on credit markets for decades. If we want rigorous competition we should develop support for new entrants. The markets will quickly weed out the strong raters from the hackers. The government will not have to make that determination. America brutally damaged economies around the world through the export of misrated structured products. Let us invest in strong, rigorous rating competition and rebuild our reputation as the most transparent capital markets in world. US debt products and their ratings should inspire confidence not skepticism.