The Market Begins to Reform the Rating Agencies Itself

By now, most people who follow finance are aware of the role the rating agencies played in the crisis. They made embarrassingly poor assumptions on the path of the housing market, and lots of incorrect ratings on mortgage-related securities resulted. Investors believed the raters' wrongly optimistic ratings, eagerly scooped up the resulting bonds, and lost gobs of money. Yet the summer's financial regulation bill didn't do much to change the way the ratings process works. As it turns out, however, the market might be taking care of the problem instead.

First, here's a quick review for anyone who wasn't paying attention back in May. Sen. Al Franken (D-MN) proposed an amendment to the bill that would have changed the process for how an asset- or mortgage-backed security is rated. It intended to require regulators to require one somewhat arbitrary agency to rate each deal, which sought to remove any conflict-of-interest that might exist. Then, issuers would have the option of hiring others to rate deals but would be forced to live with the required rating. 

Unfortunately, after passing in the Senate, the proposal died in conference, though the final legislation did require a study to examine how the new framework would work. In an interesting development, however, mere market competition is evoking unsolicited ratings that may begin to fix the conflict-of-interest problem. Check out this news from Jeannette Neumann and Anusha Shrivastava of the Wall Street Journal:

An unusual public squabble among the three largest credit-rating firms erupted over a $280 million residential mortgage-backed security that was priced on Friday, the first private RMBS deal of the year.

In a preliminary opinion, Fitch Ratings, a subsidiary of Fimalac SA of France, gave its highest grade, triple-A, to all but $10 million of the issue, which comes from RWT Holdings Inc., a wholly owned subsidiary of Redwood Trust Inc. of Mill Valley, Calif.

But the two larger ratings firms, Moody's Corp.'s Moody's Investors Service and Standard & Poor's, a unit of McGraw-Hill Cos., have offered unsolicited opinions on the same deal, raising questions about Fitch's top-notch rating.

Both of the dissenting views hinged on a relative lack of diversity in the portfolio of loans underpinning the security: Moody's noted geographic concentration in the earthquake-prone San Francisco Bay Area, and S&P focused on the large size of the home loans and the outsize risk posed by the failure of any one of them.

This is great on a few levels. First, it shows that the agencies really are serious about developing a diversity of assumptions, rather than all ruling in lock-step. It looks like the oligopoly is becoming more competitive. Imagine if this sort of thing had occurred with housing market assumptions back in 2005 -- we might have avoided much of the mess that resulted.

Second, it puts the burden of analysis on investors -- where it should be. The disagreement above stems from predictions of the future. How much should geographic diversity matter in a loan pool? That's for whoever is buying the resulting securities to decide -- not the rating agencies. No portfolio manager buying these bonds could blame the agencies this time if the investment goes bad. After all, the expected future performance of the loans depends on whom you ask, which exemplifies a realistic portrayal of predictions of the future.

This debate is very health for the market. It might make the process of selling certain securities a little harder, but the process should have been harder. This is desirable when there's reasonable doubt about assumptions used to rate securities. Let's hope that similar disputes continue to arise in the days that follow, and that investors use such discussions as an opportunity to do more of their own analysis before blindly buying based on ratings.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

How to Cook Spaghetti Squash (and Why)

Cooking for yourself is one of the surest ways to eat well. Bestselling author Mark Bittman teaches James Hamblin the recipe that everyone is Googling.

Join the Discussion

After you comment, click Post. If you’re not already logged in you will be asked to log in or register.

blog comments powered by Disqus

Video

How to Cook Spaghetti Squash (and Why)

Cooking for yourself is one of the surest ways to eat well.

Video

Before Tinder, a Tree

Looking for your soulmate? Write a letter to the "Bridegroom's Oak" in Germany.

Video

The Health Benefits of Going Outside

People spend too much time indoors. One solution: ecotherapy.

Video

Where High Tech Meets the 1950s

Why did Green Bank, West Virginia, ban wireless signals? For science.

Video

Yes, Quidditch Is Real

How J.K. Rowling's magical sport spread from Hogwarts to college campuses

Video

Would You Live in a Treehouse?

A treehouse can be an ideal office space, vacation rental, and way of reconnecting with your youth.

More in Business

Just In