The global market crash of 2008 revealed basic, inherent conflicts in the regulatory and business models of commercial rating agencies on which financial and capital markets had come to depend.

Like a dog chasing her tail, conflicts between multiple, uncoordinated, poorly conceived regulatory requirements, commercial interests of rating agencies, loan covenants, capital and leverage limitations, and market forces, have created a powerful negative feedback loop that played a part in 2008 in quickly destroying global markets.

First Problem: “Selling” ratings is like the church selling “indulgences”

In some jurisdictions (the United States, for example), regulators require that the portfolios of certain types of financial institutions, such as insurance companies, contain only securities with “investment grade” ratings, while limiting the number of agencies entitled to issue such ratings.

Some issuers of mutual funds and other collective investments, contract to only hold securities with certain ratings in their portfolios.

Market participants, in general, pay less for securities with lower credit ratings. Therefore, a down-grading of the credit rating of an issuer results in a fall in the price of its securities.

Rating agencies are paid for their ratings by issuers and compete for such business. Consequently, rating agencies have an inherent conflict of interest, tending to rate securities higher than merited when first issued.

Second Problem: Ratings become a condition of default

Some lenders make the failure of a borrower or an issuer to maintain a certain credit rating a condition of default on loans or other contracts.

Many financial institutions have capital, margin, and leverage requirements dependent upon the market value of securities held as assets in portfolio. A down-grading of securities in their portfolio can result in an institution needing to sell assets or raise capital — both actions which tend to decrease market prices of securities. Furthermore, the down-grading of securities in an institution’s portfolio, resulting in capital deficiencies, can lead to the down-grading of an institution’s own securities.

In some cases, such as ratings of credit insurers or sovereign debt, a single down-grading can effect not only a single issuer, but automatically flows through to thousands of other issuers dependent upon that rating.

Third Problem: Defaults on low ratings make the agencies look good

Ratings are supposed to predict the default rate of debt issues. The higher correlation between negative ratings and defaults, the stronger the case that rating agencies can make with investors and regulators as to the value of their services. This gives rating agencies strong motivation to quickly down-grade an issue, if default appears at all possible.

However, because of the link between ratings, loan covenants, capital requirements, and portfolio acceptability, a downgrading of ratings can force many companies into default. In other words, the rating agencies are not independent observers of markets, but are factors directly influencing markets and consequently the ratings they are issuing.

The situation is further exacerbated in the U.S. and elsewhere by the extension and strict enforcement of mark-to-market accounting and the criminalization of what, in hindsight, might appear to be over-optimistic accounting estimates by company executives or their accountants, as a result of the Sarbannes-Oxley Act and similar measures.

More than simple reform is needed

Institutions and investors have become over-dependent upon the services of a few rating agencies, rather than upon their own analysis and research.

Rating agencies have too few analysts, spending too little time, working without adequate documentation and oversight, compared to the volume and complexity of issues in the market.

Large segments of the securities market are not rated at all, while financial institutions, to save money and boost short-term profits, have reduced the number of in-house securities analysts.

The massive breakdown in the informational system supporting financial markets on a worldwide basis, and the inadequate understanding of the potential for creating a negative feedback loop between regulatory requirements, ratings, and market prices, were factors in the Crash of 2008.

The rating agency regulatory and business model is obsolete

Congress will not be able to “fix” the rating agency problem by issuing a few rules and regulations. There are fundamental flaws in the rating agency business model, that is not the fault of the agencies, but rather of changing times and increasing market complexity:

1. The largest rating agencies have staffs that are too small to oversee the more than 3.5 million securities issued in hundreds of legal jurisdictions worldwide. When administrative and marketing staffs are subtracted, the remaining analytical personnel are far short of the number of people that would be needed to study and pass reasoned judgement on this vast number of increasingly complex issues.
2. With a view to international markets, none of the major rating agencies have sufficient personnel with skills needed to cover rapidly changing laws, accounting and tax regulations, and political and economic happenings in every jurisdiction.
3. The income that rating agencies can derive from issuers and market institutions in the form of rating fees and subscription for publications is highly volatile, dependent upon the ups and downs in the market, while the actual work needed to maintain a certain level of analysis does not fluctuate with security prices.
4. Security analysis, even assisted by computers in preparing and presenting data, still is almost entirely dependent upon the time consuming brain work of highly-trained humans.

To resolve this problem would require either moving backwards in time, radically simplifing markets, instruments, institutions, and operations — something that is extremely unlikely — or the invention of some entirely new approach that will enlist the services of many more people with more skills and far less cost.

Open-source techniques used in the development of software such as Apache and Firefox, and collaborative editing of research by volunteers, such as is possible with the wiki format, suggest the way forward.

In March 2009, a collaborative encyclopedia of world capital markets was launched to address this problem. Capital Market Wiki is just in the proof of concept phase, but has been designed specifically to address inadequacies in the current rating system.

See the article: 2008 Never Again! in Capital Market Wiki.

This entry was posted on Friday, March 20th, 2009 at 2:29 pm and is filed under Capital Flow Analysis. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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