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SEC Roundtable on credit rating agency models today

May 14, 2013

I’ve discussed the broken business model that is the credit rating agency system in this country on a few occasions. It directly contributed to the opacity and fraud in the MBS market and to the ensuing financial crisis, for example. And in this post and then this one, I suggest that someone should start an open source version of credit rating agencies. Here’s my explanation:

The system of credit ratings undermines the trust of even the most fervently pro-business entrepreneur out there. The models are knowingly games by both sides, and it’s clearly both corrupt and important. It’s also a bipartisan issue: Republicans and Democrats alike should want transparency when it comes to modeling downgrades- at the very least so they can argue against the results in a factual way. There’s no reason I can see why there shouldn’t be broad support for a rule to force the ratings agencies to make their models publicly available. In other words, this isn’t a political game that would score points for one side or the other.

Well, it wasn’t long before Marc Joffe, who had started an open source credit rating agency, contacted me and came to my Occupy group to explain his plan, which I blogged about here. That was almost a year ago.

Today the SEC is going to have something they’re calling a Credit Ratings Roundtable. This is in response to an amendment that Senator Al Franken put on Dodd-Frank which requires the SEC to examine the credit rating industry. From their webpage description of the event:

The roundtable will consist of three panels:

  • The first panel will discuss the potential creation of a credit rating assignment system for asset-backed securities.
  • The second panel will discuss the effectiveness of the SEC’s current system to encourage unsolicited ratings of asset-backed securities.
  • The third panel will discuss other alternatives to the current issuer-pay business model in which the issuer selects and pays the firm it wants to provide credit ratings for its securities.

Marc is going to be one of something like 9 people in the third panel. He wrote this op-ed piece about his goal for the panel, a key excerpt being the following:

Section 939A of the Dodd-Frank Act requires regulatory agencies to replace references to NRSRO ratings in their regulations with alternative standards of credit-worthiness. I suggest that the output of a certified, open source credit model be included in regulations as a standard of credit-worthiness.

Just to be clear: the current problem is that not only is there wide-spread gaming, but there’s also a near monopoly by the “big three” credit rating agencies, and for whatever reason that monopoly status has been incredibly well protected by the SEC. They don’t grant “NRSRO” status to credit rating agencies unless the given agency can produce something like 10 letters from clients who will vouch for them providing credit ratings for at least 3 years. You can see why this is a hard business to break into.

The Roundtable was covered yesterday in the Wall Street Journal as well: Ratings Firms Steer Clear of an Overhaul - an unfortunate title if you are trying to be optimistic about the event today. From the WSJ article:

Mr. Franken’s amendment requires the SEC to create a board that would assign a rating firm to evaluate structured-finance deals or come up with another option to eliminate conflicts.

While lawsuits filed against S&P in February by the U.S. government and more than a dozen states refocused unflattering attention on the bond-rating industry, efforts to upend its reliance on issuers have languished, partly because of a lack of consensus on what to do.

I’m just kind of amazed that, given how dirty and obviously broken this industry is, we can’t do better than this. SEC, please start doing your job. How could allowing an open-source credit rating agency hurt our country? How could it make things worse?

  1. mathematrucker
    May 14, 2013 at 10:08 am

    The monopoly of the “big two” political parties might help to explain the persistence of a near monopoly of the “big three” credit rating agencies.

  2. William J. Harrington - Former Moody's Derivative SVP
    May 19, 2013 at 11:21 am

    I attended the SEC Roundtable as an observer after having volunteered to participate as a panelist. Sad takeaway – the large rating agencies don’t even represent that their ratings are accurate, ie. rating agencies don’t stand behind their products. Rather, the rating agencies merely observe that rating methodologies are publicly available and users such as issers are free to make informed choices. Seeds of another bail-out being assiduoudly planted.

  3. William J. Harrington - Former Moody's Derivative SVP
    May 19, 2013 at 11:38 am

    At the bottom of the ratings mess? Derivatives. Just as two parties to a bilateral derivative contract have leeway to value it differently, rating agencies model the same derivative contract differently depending on type of issuer.
    90% of derivatives reside in the FDIC-insured bank subsidiaries of JPM, Citi, Goldman, BoA and Morgan Stanley. Time to move the derivatives to the bank holding companies.

  1. May 17, 2013 at 9:02 pm
  2. May 22, 2013 at 6:37 am
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