Will A New Business Model Revitalize the Rating Agencies?

When discussing who to blame for the financial crisis, usually the rating agencies are one of the parties that come up. Their failure to accurately depict the risk in mortgage securities led investors to believe they were safe. This exacerbated the real estate bubble and the losses that followed. The summer's financial regulation bill had some minor reforms seeking to improve the potential conflict-of-interest that could lead the rating agencies to provide too favorable ratings. One sought to pave the way for raters to provide analyses on securities that they were not hired to evaluate. Such unsolicited ratings may soon begin to surface, but will this new product succeed?

Tracy Alloway at the Financial Times Alphaville blog notes that Realpoint is looking to get into the unsolicited ratings business. Alloway quotes an article at Total Securitization which explains that the company intends to offer ratings and analysis on a fee basis to investors. She hopes that this new trend will really take hold. I do too, but this isn't an easy business model to make work.

Will It Be Profitable?

For starters, it takes significant manpower to evaluate asset-backed securities. And these particular quant guys don't come cheap: they're highly valued on Wall Street. Traditionally, the smartest of the bunch who start off at rating agencies eventually end up at investment banks and hedge funds, which offer better pay. To keep high quality individuals, the agencies have to competitively pay these analysts, something that they have trouble doing even when they are promised fees for solicited ratings.

This new business model would necessitate the same sort of analysis, but without the guaranteed fee income. That's a pretty hard strategy to make profitable. You would probably have to steep fees for the ratings and research and sell quite a lot of it. Meanwhile, many of the biggest investors in securitized bonds already probably feel pressure to ramp up their in-house staff of researchers to satisfy clients who were angry about their reliance on ratings. Is trusting unsolicited ratings instead of doing the work yourself really cheaper or more effective? It may be in some cases, but possibly not enough to make the business sustainable for the agencies.

Will Investors Embrace The Service?

There's an even more serious problem, however. Institutional investors -- who are the ones that buy this stuff -- are paid by clients to manage their money because of their savvy and insight. By paying agencies for unsolicited ratings and research, the investors would effectively be outsourcing the heavy lifting.

This isn't likely to be something fund managers are crazy about for two reasons. First, it makes them look bad. For clients to believe you're adding value by managing their money, they have to be reasonably convinced that you have a unique talent for understanding investments. Buying the research of others casts doubt on that important criterion. Second, for this very reason, fund managers aren't likely humble enough to believe that these rating analysts can do a better job than they can if they allocate resources to evaluating these securities themselves.

While unsolicited ratings and research would be a great thing to provide more perspective on the market and various securities, a bumpy road lies ahead. These agencies need to develop a good business model and convince investors to trust their work. Neither or those hurdles will be easy to hop over.