After the ratings agencies
Among the likely casualties of the emerging financial crisis, the ratings agencies (Moody’s, Standard & Poor’s, Fitch) have to be near the top of the list. The crisis has exposed fundamental weaknesses in the way in which ratings are determined and adjusted. The privileged position held by these agencies can no longer be justified. it’s far from clear how these problems could be resolved, but I’ve set out some tentative thoughts below.
First, as the crisis has shown, the much sought-after AAA rating is virtually meaningless in itself, as is the “investment grade” rating below which securities are classed as “junk”. For some asset categories, like government bonds, it means default is virtually unthinkable. For others, like mortgage-backed derivatives, it says that, default is unlikely, provided that the assumptions used in constructing the derivatives, based on perhaps five years of data, remain valid. Translated that means the probability of default is somewhere between 0 and 100 per cent. Vast numbers of such securities have been downgraded from AAA to junk in the last year, and all are appropriately regarded as being in the “jun” (that is, speculative) category.
This produces some absurd results. For example, Ambac, a mortgage insurer whose shares have lost 92 per cent of their value in the past year, is rated at AA by Fitch. By contrast, Greece, a Eurozone member country, is rated A. Does anyone seriously think the probability of default by Greece is greater than that for Ambac? And Fitch is conservative. Moodys and S&P still have Ambac rated as AAA suggesting, to anyone foolish enough to believe them, that the probability of default is negligible.
State and municipal governments are beginning to rebel against the system of discrimination under which municipal bonds get rated around six grades lower than corporate bonds of comparable quality. That’s the estimate of the agencies themselves – the reality is far worse. As the NYTimes notes, “since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings.”
Again from the NYTimes “. Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things.” But lots of organizations are required by charter or legislation, to invest only in AAA, or only in investment-grade securities, and lots of funds advertise to retail customers that they invest only in AAA-rated securities. Fairly clearly, such requirements are inconsistent with the fiduciary obligations they are supposed to enforce.
What could replace reliance on ratings agencies? For those who want a reasonably secure guarantee against default, the best advice at present would be to restrict investments to those with an explicit guarantee from a developed-country national or state government. An obvious implication is that states would need to guarantee, or borrow on behalf of, municipalities and agencies. This is already done on a substantial scale for example by Queensland Treasury Corporation.
Looking at the corporate sector, it’s pretty clear that restoring the credibility of ratings agencies will require a lot of improvements to independence and transparency. The situation under which securities issuers solicit ratings from agencies is one obvious problem. So is the willingness of agencies to rate complex securities based on limited modelling.