They’re planting the seeds for a consensus alternative to traditional rating agency models.
The rating agencies are faced with another existential crisis for their business models. On the one hand, financial reform legislation might turn them into public utilities. And on the other, the Securities and Exchange Commission, if its Well’s Notice to Moody’s is to be taken seriously, is opening the latest legal challenge to strip their ratings of their First Amendment shield, thereby opening them to lawsuits that could quickly render them insolvent.
Politicians meanwhile are talking out of both sides of their mouths, saying that rating agencies were either not rigorous enough (in the case of structured CDOs) or too rigorous (in the case of concerns about sovereign debt levels). One solution, then, is to dictate what they can cover and influence what they can say. In this sort of reality, needless to say the prudential value of ratings for investment policies or financial regulations ratings will become even more questionable. So what will regulators do?
For one, they are scrambling to find alternative arbiters of credit risk that they can easily draft into new regulatory language. As treasurers know in seeking to the same for their company’s own investment policies, this is no easy task. There are certainly plenty of candidates, but the government’s own long-term policy of embedding the Big Three ratings into its investment rules has raised significant barriers to entry.
In the meantime, another route would be to supplement rating language in regulations with requirements for investors to perform and attest to their own risk assessments to validate that of the external rating agencies. This, of course, runs counter to both the inclination and resources of the great majority of institutional investors around the world, but shouldn’t be dismissed outright nonetheless.
A first step in this direction is seen in the SEC’s proposed rules for asset-backed securities, whereby among other things, issuers would be required to provide ample data in machine readable format (e.g., XML) so as to allow investors to perform their own analysis—in other words, create their own rating. While initially, this self-analysis could be compared against the letter grades of the rating agencies, eventually a poll or consensus rating might be formulated using these investor-generated “ratings” as they are disclosed. It wouldn’t be long before some service or competing services would seek to collect and aggregate these investor-generated ratings. Again, these would probably have the vanishingly small predictive value of consensus forward earnings per share estimates aggregated by Bloomberg and its competitors, but would at least provide a broader market view to test the raters’ own estimates.
Indeed, such a consensus might be preferable to credit default swap spreads, which reflect the opinions of entities with no real understanding of the underlying’s credit. At least with the ABS, there would be some data for those investors with analytic gumption and resources to work with.
Once the market accepted one of the new aggregators’ consensus rating, regulations could move from having entities validate a Moody’s or S&P rating to the consensus number—and perhaps the current NRSOs would get into this business themselves. While this could substitute one set of flawed analysis for another—imagine if stock investment guidelines were determined by consensus forward EPS estimates—it might provide some advantage to current ratings oligopoly.