In an article “berating the raters”, Paul Krugman points to a proposal by Matthew Richardson and Lawrence White who suggest that the SEC create a centralised clearing platform for ratings agencies. Each issuer that would like its debt rated would have to approach this platform which would then choose an agency to rate the debt. The issuer would still have to pay for the rating but the agency would be chosen by the regulator. In their words, “This model has the advantage of simultaneously solving (i) the free rider problem because the issuer still pays, (ii) the conflict of interest problem because the agency is chosen by the regulating body, and (iii) the competition problem because the regulator’s choice can be based on some degree of excellence, thereby providing the rating agency with incentives to invest resources, innovate, and perform high quality work.”
The critical assumption behind the idea of a centralised clearing platform is that the total notional of bonds that exist and need to be rated is constant i.e. it assumes that the actions of the ratings agencies only divide up the ratings market and do not expand or contract it. So for example, a trillion dollars worth of bonds would be issued each year and the regulator would choose who rates which bond thus ensuring that none of the rating agencies are incentivised to give favourable ratings to junk assets. This assumption may hold for corporate bonds, but it is nowhere close to being true for structured bonds like CDOs which were the source of the losses in the crisis.
There are some fundamental differences between the ratings process for corporate bonds and the process for structured products such as CDOs. Whether a corporate bond is issued or not is usually not critically dependent on the rating assigned to it. For example, the fact that a corporate bond is rated as BBB instead of single-A will most likely not prevent the bond from being issued. A firm usually decides to undertake a bond issuance depending on its financing needs and unless the achieved rating is dramatically different from expectations, the bond will be issued and fees will be paid to the ratings agency.
On the other hand, whether a structured bond is issued or not is critically dependent on the ratings methodology applied to it. A structured bond is constructed via an iterative process involving the bank, the investor and the ratings agency. If the ratings methodology for a structured product is not generous enough to provide the investor with a yield comparable to equivalently rated assets and to enable the bank to earn a reasonable fee, the bond will just not get issued. When it comes to structured bonds, bonds are not created first and rated next. Instead the rating given to the bond is critical in determining whether it is issued and correspondingly, whether the ratings agency gets paid.
If each one of the ratings agencies that are part of the centralised platform adopts a stringent ratings methodology that destroys the economics of the trade, the bond is not issued and none of the agencies earns the fee. In this manner, the agencies are still incentivised to loosen their standards even in the absence of competition from other agencies. When it comes to structured bonds, ratings agencies have historically been focused as much on expanding the market as competing with each other. Indeed, the biggest catalyst in expanding rating agency profits over the last two decades has been the steady expansion of the universe of products that they were willing to rate using a generous methodology from vanilla bonds/loans/mortgages to tranches of bond portfolios to tranches of synthetic exposures to even complex algorithms and trading strategies – the crowning example of the last variety being the CPDO. Even when one of the agencies was the first-mover in rating a new product, it could not adopt too stringent a methodology for fear of killing the deal altogether.
Moreover, the very notion of restricting the choice of agencies that can rate a given structured bond is an oxymoron given the iterative process – let us assume that a particular type of structured bond is leniently rated by only one of the three ratings agencies. If the agency assigns the bond at random to another agency, the bank can merely make a small modification to the underlying portfolio and try its luck again till it gets allocated to the right agency. The inherently iterative ratings process also explains why the furore over ratings agencies making their models public is a red herring, as I have explained in a previous post.
I am not claiming that competition between the agencies did not make things worse at the margin in the financial crisis. But a tangible difference to the outcome in the crisis would have been achieved only if the ratings agencies had adopted such a stringent methodology that would have caused subprime CDOs and many other leveraged/risky structures to not be issued at all. Given the demand for AAA assets with extra yield (driven by internal and external regulations), this could have been achieved only by an explicit ban on rating such structures. Else, even if there was just one monopolistic rating agency that was paid by the regulator, the agency would have been almost as aggressive in rating new structures just because of the indisputable fact that the agency got paid only when a deal got done, and lenient ratings standards got more deals done.