SPECIAL IDEAS REPORT

Idea of the DayTuesday, June 30, 2009

Cut Out the Rating Agencies

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Virtually everyone agrees that some of the blame for the financial meltdown should fall on the shoulders of the rating agencies, which led investors astray by failing to accurately evaluate the soundness of mortgage-backed securities. Rating agencies could be reformed in several ways, but of the various options, my favorite solution is to get rid of them altogether.

After all, if investors were given the tools to evaluate risk themselves, the rating agencies would become obsolete. While it might be easy to see how this would work for unsecured corporate debt (since investors don't need the rating agencies' permission to buy stocks), mortgage- and asset-backed securities pose a different, but I think solvable, problem.

The basic way a mortgage-backed security transaction has traditionally been brought to market is as follows:

  1. An issuer tells an investment bank it has a pool of mortgages it would like to securitize.
  2. The investment bank obtains the mortgage-pool data from the issuer, aggregates the data, and has it validated by a third-party accounting firm. That accounting firm also usually performs some due diligence on the mortgage pool.
  3. The investment bank creates a proposed bond structure, based on what it believes investors would be interested in purchasing.
  4. The investment bank then shares issuer data, aggregated mortgage-pool data, and the proposed bond structure with the rating agencies. The agencies at this point either validate the investment bank's proposal, or determine that the variables the bank relied on are faulty, in which case the bank must make changes - many times infusing the deal with more capital so as to offset risk.
  5. Finally, the investment bank offers the new mortgage-backed bonds to investors, based on rating-agency requirements.

The role of the rating agencies in this process is vital, as they're the ones who dictate to the investment banks what assumptions, including estimated losses and prepayments, need to be used in order for the bond structure to achieve certain ratings. And it's those assumptions that determine just how safe or risky the securities actually are.

So how would things work if investors were to play this role instead of having to trust an oligopoly of rating agencies? Let's change steps 4 and 5 above -- the ones that involve the rating agencies:

  1. The investment bank then shares issuer data, aggregated mortgage-pool data, and the proposed bond structure with investors. The investors at this point either validate the investment bank's proposal, or determine that the variables the bank relied on are faulty, in which case the bank must make changes - often infusing the deal with more capital so as to offset risk.
  2. Finally, the investment bank offers the new mortgage-backed bonds to investors, based on their own requirements.

The difference is that investors would be calling the shots. Since they're the ones buying the securities, this is logical.

Of course, these deals may take a bit longer to close, since investors would need time to evaluate all the raw data, and would want to do this carefully. (As things stand now, investors don't get access to this data until the deal has been finalized and announced to the market.) But in the end, a little extra time seems a small price to pay for investors to be able to control their own destiny.

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Comments (2)

interesting... but is there danger that competing firms would become single-share investors in everything to try to get an "insider" edge?

also... investors are probably more prone to swells of overconfidence. The ratings agencies do as well, but to a lesser degree. Wouldn't this just make bubbles worse?

If Ratings Agencies didn't exist, someone would invent them. They'd figure out a way to signal major institutional credit (probably by stacking the board with Titans of Industry). The ratings would be optional, of course, but how long do you think it would take before anything without a rating from one of the big firms was considered junk?

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