Monday, March 16, 2009

Rating Agency Model Debate

As it pertains to a previous piece of ours, entitled: Issuer vs. Investor-pay Model, New York State's Insurance Superintendent Eric Dinallo wrote an op-ed piece for the Wall Street Journal proposing the investor-pay model.

Michel Madelain's (COO of Moody's Corp.) response was displayed in the letters to the editor section. Here is our response:

Dear Editor,

New York State Insurance Superintendent Eric Dinallo’s March 3 piece (“Buyers Should Pay for Bond Ratings” ) argues against the rating agencies’ issuer-pay model and their “powerful incentives to bias ratings to keep debt securities’ sellers satisfied and the rating fees flowing.”

While supporting Mr. Dinallo’s initiative, we suggest that his proposed investor-pay model is similarly flawed.

Here’s why. Particularly in structured finance ratings – the area of increased scrutiny today – the issuer has little or no “skin in the game”: Only investors holding securitized bonds are affected by the actions of the rating agencies. Therefore, under Mr. Dinallo's proposal, the only party that has skin in the game would be responsible for paying the rating agencies’ fees. We believe the resulting pressures imposed by investors on rating decisions would be at least as intense as those imposed by issuers or structuring banks.

To combat the inherent conflict of interest, one could align the rating agencies' fees with the performance of each bond, as benchmarked against its rating. Thus, if a AAA behaves like a CCC, it won’t be compensated for as a AAA would.

More importantly, as Mr. Dinallo mentions, “ratings will never be flawless.” The Holy Grail is, thus, to de-link the world’s financial stability from ratings performance. We concur with the essence of Sean Mathis’ September 27, 2007 testimony before the U.S. House of Representatives’ Committee on Financial Services:

“…I believe, however, that the true culprit [is] the system that allowed NRSRO ratings to become critical and an embedded part of the protections built into our capital markets, financial institutions, and pension funds without sufficient or appropriate thought given to accompanying supervision or accountability.”


Gene Phillips and Guillaume Fillebeen
Directors, PF2 Securities Evaluations, Inc.

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