Central Pricing Solution

It continues to worry us that asset prices can be, or are, subject to conflicts of interests and inflationary pressures.

As an independent valuation consultancy we’re naturally disagreeable about market participants seeking valuations from biased counterparties like asset managers or even the broker dealers who sold them the bonds or are funding their holding of the bond. Scion Capital’s Michael Burry explained in The Big Short: “Whatever the banks’ net position was would determine the mark.”

But even aside from potentially conflicted external parties, we’re acutely aware of the inflationary pressures independent parties such as ourselves may face when evaluating a security. Similar to “ratings shopping” opportunistic market participants often seek out the provider willing to give the highest prices.

The incentive is clear: higher asset prices translate into stronger performance. Stronger performance may directly benefit an executive or employee (to the extent performance fees or bonuses are based on returns) or even indirectly improve a fund’s prospects (heightened ability to raise capital or negotiate decreased margin requirements on the back of strong performance).

While prices have been regularly contested problems are starting to crop up more and more regularly, with questions about mutual funds’ municipal bond pricings and Berkshire Hathaway’s pricing and writedown practices finding their way into the news in the last two months.

There’s no easy solution, but one we feel strongly about is the creation of a centralized analytical (read pricing) solution.



The cost of creating such a system could be shared among its users. The advantages are numerous. Here are a few:

• If all holders were required to hold the same security at the same price, the result would be greater balance sheet consistency (across funds, companies)

• Regulators, auditors and examiners would have an easier time analyzing their constituents’ books: they would be able to rely on a single, consistent model that is widely used. (The prevailing, seemingly inefficient alternative is to have each regulator/ auditor/examiner familiarize herself with the methodologies employed by each and every pricing provider used by each company scrutinized. This is no mean feat, especially across different asset classes, and so naturally a lot will slip through the cracks.)

• Pricing consistency helps reduce portfolio-level variability and also helps the market overcome some of the uncertainties that come with informational asymmetries and modeling complexities in today’s market. Consistency and confidence together help promote market liquidity.

Looking for a Mis-Rated Subprime Bond?

As we combed through the latest list of subprime RMBS ratings downgrades, we found some astonishing actions, like AA ratings being reduced to CCC in one fell swoop. (Source: S&P's March 16 press release, entitled: S&P Lowers 172 Ratings On 39 '03-'04 US Subprime RMBS Deals, see for example Fremont Home Loan Trust 2004-3 Class M4.)

But one in particular caught our eye:

Welcome to Morgan Stanley ABS Capital I Inc. 2004-NC5 Class B4

Rated C by Moody's and CC by S&P (the lowest and second lowest ratings respectively), the bond paid off in full.

Click to enlarge


As the chart shows, this bond didn't suddenly pay off in full, catching the raters by surprise. Rather, it paid down ever so slowly, but consistently, especially over the period from February through November 2010. (The factor describes the percentage of the bond's par value outstanding at any time, as a percentage of its original face value. In this case, it went from 100%, or 1, down to approximately 20% in mid '07, and then down to 0%, ultimately, in November 2010.)

But wait, this gets better: while S&P simply denotes the CC rating as being withdrawn (as opposed to being paid off in full), as per their procedure, Moody's skips over the B4 class in its March 15, 2011 press release entitled: Moody's downgrades $2.75 billion of Subprime RMBS issued by Morgan Stanley in 2000 through 2004
 
We did a little checking. First we wanted to verify from the deal's trustee report that class B4 really did get all its payments. Turns out that not only did the B4 pay off in full (four months ago), but the C-rated B3 notes, still outstanding, are paying off handsomely too. Since Moody's downgraded the B3 notes (CUSIP 61746RGA3) to C in Feb. 2009, they've paid down more than 56% of their balance!

The bond continues to pay (as of Feb. distribution), and now has a factor of just under 11% remaining. It's currently rated C, CC and C by Moody's, S&P and Fitch, respectively.

Click to enlarge

Update: Feb. 2012: tranches B, C, D and E of Parkridge Lane Structured Finance Special Opportunities CDO I Ltd. were withdrawn after paying down in full. They paid down slowly over time. At the time of final payments, the B notes were rated Caa1 by Moody's and CCC+ by S&P. The E notes were rated Ca by Moody's and CCC- by S&P.
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For similar funky findings, click here or here or here. For our coverage of weird (usually structured finance) model errors, click here.

Christine Richard, on Confidence

Earlier this week, Expect[ed] Loss sat down with Christine Richard, author of Confidence Game. If you haven’t already read the book well firstly shame on you. The paperback’s due out next week so pick it up. It’s a vital story.

Briefly, the book tells of a hedge fund investor’s campaign to bring attention to what he felt to be material shortcomings within a AAA-rated, systemically important insurance company. He’s short their credit default swap, which means he stands to profit if other market participants, authorities, rating agencies or regulators can be convinced to agree with his take. Of course, he walks the line between good and evil: he provides a material public good in a way in warning of a systemic concern, but in doing so his warnings serve to cloud the viability of a systemically important public company, while creating a profit for him.

We’re not here to spoil the book for those of you who haven’t read it yet. But we’re going to provide you with a couple of snippets from our conversation. Any wisdom coming from the interview belongs to Christine. Any errors are ours.


EL: Christine your book describes activist investor Bill Ackman’s crusade, and really it’s quite a lonely crusade isn’t it, against an insurance company he believed to need reforming and perhaps a whole system he felt was broken. Having seen how reform and regulation has transpired since, how the world has moved on, well has it affected your perception of the value of your work. Was the book fulfilling to you?

CR: I'm pleased with the book and the response I've gotten from people who've read it. I think it succeeds in combining a very human story with the larger story about what went wrong on Wall Street. I do find it discouraging that the FCIC left the role of the bond insurers out of its 500-page-plus report. I think that the loss of confidence in the triple-A ratings of companies like MBIA was the beginning of the unraveling of everything. Most of the companies have crept quietly off the stage but still I think the story of their collapse is worth understanding. They were the first, really, to figure out that the triple-A rating was one of the most powerful brands in the world. Before the crisis, their collapse was unthinkable. Even the idea that they might be downgraded to AA from AAA was unimaginable. It shows you just how fragile and delusional the financial system had become.

EL: Companies can fail for all sorts of things, often trace-able to poor communication between management and the board and shareholders. But here that wasn’t really the problem – Ackman, like Harry Markopolos in a way, was all about communication. He went to regulators, to the attorney generals, to the executives at the ratings agencies. He wrote detailed reports, ran extensive analyses, produced an open source model at a time in which analytics were expensive and the market opaque. What can be taken from all his efforts? All these authorities he went to that were deaf to his comments - did they all just have a distortion field around them at the time?

CR: Some of the reasons people wouldn't listen to Bill were obvious. It wasn't in their interest to be critical of a company that could turn any bond into a top-rated security. For a while, the main business of Wall Street was manufacturing triple-A-rated securities. I also think there were psychological reasons that people didn't want to listen. No one wants to be told how to do their job or that they have it all wrong. Plus, Bill had this huge financial motivation to scare people about the bond insurers so that he could make money on his credit default swap position. It was hard to look beyond the self-interest and really think through the argument. Above all, the triple-A credit rating shielded the company from critics.

EL: When we read interviews of Inside Job director Charles Ferguson, they often ask him about the language barrier of finance. Overcoming the barrier might be quite difficult for some reporters who are not too familiar with finance. Now I know you’ve been covering the debt market for many years at Dow Jones from well before you were at Bloomberg. And you’ve written a page turner, you really have, it’s remarkable. But was there a, how do we say it, complexity barrier for you to overcome?

CR: The financial system became so unbelievably complex. And, bond insurance layered more complexity on top of complexity. I didn't want to shy away from writing about credit default swaps or collateralized debt obligations but I was always conscious that I needed to quickly offset the technical explanations with something a human being could relate to. Bill's willingness to share his personal experiences, to let me look through thousands of emails and to interview his friends and colleagues made it possible to write a story that's as much about human nature as it is about bonds or credit default swaps or collapsing mortgage securities. One of my favorite parts of the book is when Moody's finally puts MBIA under review and Bill is at his grandmother's 90th birthday at the Plaza Hotel. He's trying to piece together how a credit rating downgrade might unravel the whole company and how that is going to trigger payments of billions of dollars on his swaps. Meanwhile, the waiter is holding up a cake and his family is singing Happy Birthday and he's trying to sing and to read Bloomberg headlines and communicate with his trader on a Blackberry under the table.

EL: You mention even at Dow Jones that there wasn’t much patience for your investigative tendencies, your interest in digging deeper. And you’ve mentioned to me before the pressures to keep current – how nobody wants you going back and following up on stories of the past. Is this the new normal?

CR: It's a big part of what business journalism aspires to do -- to give people information to trade on, to move stocks, to make profitable predictions. Maybe it explains why the M&A reporters get so much of the attention. I've always enjoyed telling stories more than making forecasts. In the case of MBIA, I found the company's history of covering up losses so fascinating because it revealed its vulnerability. It had to be infallible or it was finished. That made going back and looking at the past important. The past held all the clues about what was going to happen.

EL: Christine before I let you go I want to ask you one thing – does Bill inspire you?

CR: I spoke with Bill for six years before I started writing the book. What I enjoyed most about our interactions was his enthusiasm for the research. He was fanatical about figuring out what made the company tick, and he seemed to have more fun reading financial statements than anyone I've ever met. He also just has this incredible optimism. He'd come back from a meeting with one of the credit rating agencies (back in the days when he was giving two-hour long presentations about why MBIA should be downgraded and he was being ignored) and an employee at Pershing Square would ask how it went. It was always the same response -- "On a scale of one-to-ten, the meeting was definitely a ten." Eventually, people didn't even bother to ask Bill about meetings, they just looked at each as he came through the door: "Ten out of ten?" "Yep, ten out of ten?" It's a great message about believing in yourself and persevering when the world thinks you're wrong.

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To read more about the Confidence Game, click here.

The Curious Case of Carrington

With Carrington having been in the news of late, we thought we would investigate the performance of one of its bonds.

Today's bond is currently rated A2 by Moody's (MCO), CCC by Standard and Poor's (MHP), and CC by Fitch. (Carrington Mortgage Loan Trust, Series 2004-NC1 ; Class M2 ; CUSIP: 144531AF7)

This residential mortgage backed security (think "toxic asset") survived through to 2009 before first being downgraded by Fitch. Standard and Poor's followed suit in 2010. Moody's retains it at its original A2 rating.

Split ratings like these, in an ideal world, provide a trader with an ideal opportunity to profit if she can correctly express her opinion as to the credit quality of the bond. Of course, there's no simple mechanism for shorting a RMBS security that you think is over-rated -- but buying a bond you believe to be under-rated can provide handsome rewards, if you're right.

The Proof is in the Shadow

We did some work last year detailing the dynamics of the multi-billion dollar negative basis trade, the off-balance sheet trade that helped bring several insurers to their knees, as well as a number of banks including UBS (as soon as the trade was forced back onto their balance sheets).

The lack of financial reporting transparency was only one of the problems.  Some parties, of course, had insight into the multi-trillion dollar shadow banking system. But two other major pitfalls spring to mind: the lack of asset transparency (that is the ability to understand what is being referenced) and the lack of pricing transparency (that is the ability to know the value of an opaque asset).

The lack of transparency is entirely convenient to those in the know: it creates numerous opportunities to take advantage of those with less information. We call this imbalance an "informational asymmetry."(Click here to visit the appropriately titled Fed's report "Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?"

While 2010's Dodd-Frank Act attempts to add asset transparency in various forms, it was interesting to note Frank's disheartened tone, yesterday at the House Committee Hearings on Financial Services, when speaking of the other "transparencies."  Here's an excerpt of his commentary (emphasis added):

"Hedge funds will remain uncovered.

We gave the CFTC the mandate to begin to regulate derivatives, including mostly -- including for end-users, making public the price. Not for end-users in any other way regulating them. What we did then was both derivatives and with regard to hedge funds and private equity was to get some more information. People have been talking about the shadow banking system. Well, one of the things we did in the bill was to try to bring that out of the shadows. But as a result of the Republican budget, neither the SEC nor the CFTC will have the money to do that.

And so we will back, I from time to time talk about old radio programs. I think we have another one.

Who will know what risk lurks in the heart of the financial system?

And the answer is, the shadow will know. But nobody else.

Because our efforts to put some light on the shadow banking system, by having hedge funds register with the SEC and have them be able to calculate what's up, and having derivatives regulated by the CFTC, those won't happen."

Risk - Discombobulated

Investing brings with it many risks. When things go wrong, they often tend to go wrong in concert: credit risk and market risk and illiquidity risk and complexity and legal and operational risks can all be confused and are often indistinguishable, especially when they need to be realized.

Certain rating agencies have specific ratings for these "non-credit risk" measures. One can get a liquidity rating, a market risk rating, even a trustee quality rating or a hedge fund operational quality rating.

But credit risk doesn’t exist and typically isn’t measured in a vacuum – at least not according to recent ratings criteria. When a product is exposed to operational risk, for example, failures in operational quality can bring down the credit rating itself, making it very difficult for an investor to separate the different risks being measured.

For example, Moody’s today announced that its soon-to-be-released operational risk guidelines could result in rating actions (primarily downgrades from the sounds of it) on the senior ratings of up to 200 structured finance ratings.

"The performance of a securitisation transaction depends not only on the creditworthiness of the underlying pool of obligors, i.e. the quality of the collateral, but is also closely linked to the operational performance of various transaction parties such as the servicer, trustee and cash manager"

With investors looking increasingly to non-traditional investments for heightened returns, and with banks pushing risky activities into the opaque shadow banking system (to minimize regulation and oversight), it’s high time we all started to manage our risks out of one centralized division. That way credit risk doesn’t escape the market risk team, and funding risks don’t escape the credit guys.

Corporate Governance for the Shareholders (Part 1)

2010 and the Dodd-Frank Act ("DFA") brought to the fore Say-on-Pay and certain other delights for those investing in shares of financial institutions.

DFA enhances the SEC's enforcement abilities, while creating an additional watchdog (the Consumer Financial Protection Bureau) which has both examination and enforcement capabilities. It also demands that both companies and regulators reduce their dependence on credit ratings: over-reliance on credit ratings served to exacerbate the depth of the financial crisis, as rating downgrades precipitated further pricing pressures.

Indeed, in our experience several regulatory bodies have approached the new regulatory landscape with a zest and energy that was perhaps absent in the years leading up to the crisis.

Having said that, many critics feel that financial reform measures fell short; some are critical of the regulators' enforcement intent (see here and here), especially as they experience budget constraints; others are skeptical of the newly-created FSOC's ability to even define systemic risk, never mind recognize or measure it.

What other improvements, then, can be introduced to protect against large-scale business risks at financial institutions?

Risk Must Have a Voice

We would like to see Risk have a voice. Certainly, many risk managers were very good at measuring risk. But their institutions failed anyway. Why? Often, the objectives of risk management (preservation of capital reserves) run counter to the growth objectives of the CEO, who is incentivized to put capital to work. One could argue that the too-big-to-fail banks are or were long risk, knowing that they had large potential short-term upside and low downside given the (implicit) government guarantee. The government or the taxpayer, in this scenario, is short risk. One option is to ensure that the chief risk officer reports directly to the board, rather than to the CEO. Again, if the CEO is the chairman of the board, risk's voice may be dampened and this may provide a warning sign.

Risk and Compliance Must be Independent

Similarly, it is crucial that risk managers and compliance officers are incentivized, and safe, to voice their concerns. As a cost center with relatively limited bonus potential, shareholders ought to recognize that "at-will" risk and compliance managers -- especially if they are (intentionally) over-paid -- often have little advantage for being right but significant downside for being wrong. (Click here for an example of objections ending poorly for "at will" employees.)

-End Part 1

We will be exploring further avenues for improvement in subsequent pieces of this series, including a discussion of management's communication of its risk appetite. If you have any corporate governance suggestions you would like us to consider or include, feel free to email them to us or leave them in the comments section below this post.

Deferred 4 Ever

One of the problems we come across when we examine the models our clients rely on is the incorrect modeling of the payment of deferred, or capitalized interest.

What do I mean?

If you model enough CDO deals, you'll notice that it's not always clear when a deal should be paying the deferred interest on a PIK-able bond. Obviously, in good times, this isn't a big worry but, in bad times this could make the difference between having a noteholder receiving some return vs. no return on his investment.

This is especially meaningful in TruPS CDO world where a good portion of mezzanine bonds are currently in deferral.

I pulled the following steps from a TruPS CDO's Priority of Payments (that section is found in the deal’s Offering Memorandum and defines how the liabilities are paid on each distribution date):

The B1s are entitled to receive interest here:

“SIXTH: to pay Periodic Interest on the Class B-1 Notes at the Applicable Periodic Rate and the Class B-2 Notes at the Applicable Periodic Rate, pro rata based on the amounts of Periodic Interest due;”

And principal here:

“EIGHTH: to pay an aggregate amount equal to the Optimal Principal Distribution Amount, in the following order, (a) principal of the Class A-1 Notes until the Aggregate Principal Amount of such Notes has been reduced to zero, and then (b) principal of the Class A-2 Notes until the Aggregate Principal Amount of such Notes has been reduced to zero, and then (c) principal of the Class B-1 Notes and Class B-2 Notes, pro rata, until the Aggregate Principal Amount of such [B-1 and B-2] Notes has been reduced to zero;”

Where does deferred interest fit in, in the above steps?

Well not under the definition of Periodic Interest:

“With respect to the Class A-1 Notes, the Class A-2 Notes, the Class B-1 Notes and the Class B-2 Notes, in each case interest payable on each Payment Date on such Notes and accruing during each Periodic Interest Accrual Period at the Applicable Periodic Rate.”

Nor the definition of Aggregate Principal Amount:

“With respect to any date of determination, (a) when used with respect to any Pledged Securities, the aggregate Principal Balance of such Pledged Securities on such date of determination; (b) when used with respect to any class of Notes, as of such date of determination, the original principal amount of such class reduced by all prior payments, if any, made with respect to principal of such class; and (c) when used with respect to the Notes, the sum of the Aggregate Principal Amount of the Senior Notes, the Aggregate Principal Amount of the Senior Subordinate Notes and the Aggregate Principal Amount of the Income Notes.”

Why does any of this matter? Can’t deferred interest be paid in either step?

Sure but the problem here is that choosing to pay deferred interest in one step over the other could have a huge impact on the cash flow to various notes.

Imagine the B-1s have $30 million in deferred interest. If that amount is paid under step SIX then the B-1s’ deferred interest is prioritized over the senior notes’ principal. If you go with step EIGHT, the opposite occurs. It’s a zero sum game, but either way, someone loses a good chunk of change based on the adopted interpretation of this vague language.

P.S. this is a common issue that you’ll find in CDOs backed by all types of assets (not just TruPS) so make sure your forecasting models are tuned to this properly.

The Psychological Biases of Holding Downgraded Bonds

The early days of this economic slowdown brought to our attention a plethora of examples of investors choosing to hold on to downgraded bonds in the belief that “they will come back again,” and that “it is only a temporary market dislocation.”

(Incidentally, it is not traders alone who fall prey to the “return-to-normalcy” ideology. Many of us carry the internal belief, for example, that all will be well immediately a blundering institution recognizes its folly. Being exposed to one’s folly, and fixing it, however are two different things. Thus, history tends to be allowed to repeat itself.)

From a strict utility function perspective, opting to hold on ought probably to prove the inferior choice: downgraded bonds tend to be more likely to be downgraded (again) versus comparably-rated bonds that have yet to be downgraded; moreover, the risk of an associated exponential increase to reg. capital radically changes the risk-return profile of the investment.

But there are a number of psychological forces in play that make investors particularly vulnerable to the need to hold downgraded securities whose market value is quickly diminishing.

Psychological Biases

First is the obvious — that investors exhibit risk-seeking behavior in the face of losses while being risk-averse in the face of gains.

Next, investors originally held some derivative of an innate belief that the rating agencies possessed magical capabilities and material non-public information which resulted in their original ratings being correct and any subsequent rating changes posing mere caveats before the return to normalcy. This “everything will come back again” mentality demonstrates at least two behavioral biases: (i) representativeness, the willingness of investors to base their decisions of superficial (or artificial) characteristics as opposed to underlying probabilities, and (ii) conservatism, the willingness to cling to a prior belief despite the receipt of new information.


Were They Right?

The answer is... sometimes.

Here are certain factors that should be taken into account, followed by a solution to the quandary:

First, rating agencies’ actions are often retroactive: the rating action only occurs well after the fact. In some cases, that means that as an investor you can look directly at the current situation to gauge whether subsequent upgrades are imminent.

Example: according to information we have been provided, one rating agency began downgrading collateralized loan obligation (CLO) securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to “normal” levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.

According to JPMorgan data, the spread levels on 5yr LCDX tightened from 556 basis points to 377 basis points over the relevant Sep. ’09 to May ’10 period, demonstrating the market’s interpretation of decreased credit risk on similar loans to the ones in CLOs. Next, Wells Fargo data show that whereas almost half (49.3%) of CLOs were failing their junior par coverage test as of mid Sept. 09, less than one fifth (18.86%) were still failing as of early May 2010. This key ratio perhaps best describes the improved performance of CLO securities.

Thus, in a market when the rating agency should have been upgrading bonds on a net basis, it (perhaps retroactively) downgraded more than 75% of all CLO bonds rated by them, including 76.27% of all triple A securities they rated, the market was already well into its turnaround and continued to improve. Those downgraded bonds are now being swiftly upgraded.

In other cases the “hold-to-normalcy” trade hasn’t worked as well: trust preferred (TruPS) CDOs seem continuously to be downgraded, as bank failures and bank deferrals continue to plague this market. While in certain markets default rates were significantly lower in 2010 than 2009, there has been an approximately 20% increase in bank defaults this year (annualized) versus in 2009. The credit performance of certain tranches, unfortunately, may never return to their pre-crisis levels.

In it in this light that S&P’s announcement last week was so interesting to us. S&P placed 1196 bonds on CreditWatch negative as they “incorrectly analyzed the timely interest payments, and did not incorporate an analysis of the effect of interest paid pro rata on the senior securities (that, all else being equal, inherently contain lower credit protection than those in which the interest is paid sequentially) for those transactions that have this structural feature. Approximately two-thirds of the classes affected by this CreditWatch action are from transactions issued in 2010 and approximately one-quarter were issued in 2009.”

(To be clear, their misrating of RMBS re-REMICs was not the interesting element. A week prior to this announcement we submitted to the Financial Times a comment letter that described the continued misrating of these securities, click here www.ft.com/cms/s/0/c51bb428-072c-11e0-94f1-00144feabdc0.html. We cite a Re-REMIC rated AAA in 2008 that currently languishes in the CC region.)

The magnitude is certainly severe, but the confession is the focal point, as it allows investors to immediately recognize that, wait, these bonds were incorrectly rated and contain risk in excess of that originally estimated by S&P. In publicly admitting to their error, a true “investor service” was provided to the investors by S&P. Naturally, one might be less enthusiastic about this announcement if one were to own a to-be-downgraded bond.

The next question, of course, is who else rated these bonds? And which rating agencies chose not to rate the bonds as a result of their model not being able to achieve the high ratings S&P's model produced?


The Solution

If you’re an investor, we suggest due diligence. Look into the assets being downgraded. If reg. capital is a question for you as a bank or insurance companies — or margin for leveraged funds — build a model to capture probabilities of being right versus wrong, pre-decision. Work out the probability that a large downgrade is to be followed by an upgrade, versus subsequent downgrades, asset-class by asset-class.

Welcome to the brave new world of investor due diligence.

Meredith Whitney and the Future of Credit Rating Agencies

The popular media are harping on the wrong issue in respect of the future of the credit rating agencies. They say that despite financial overhaul aimed at reducing their influence, “credit raters keep their power” (WSJ Nov. 16) and that “[for] potential newcomers, … , it is difficult to compete against established agencies [like Moody’s and S&P].” (FT Nov. 19)

Rather, the regulatory proposals in both the U.S. and Europe have been quite severe on the rating agencies, demanding both improved transparency and enhancing transparency, which increasing the potential for legal liability; and the very reason that players like Kroll and Meredith Whitney are entering the rating environment is that the established agencies are particularly vulnerable to competition.

To be fair, it is always a challenge to compete against a well-established company. But Kroll and Whitney are seizing the opportunity while the raters are weakened by poor ratings performance, and distracted by the significant increase in both the “volume and cost of defending such [related] litigation.” - from Moody’s (MCO) 10Q

Ratings, as we all know, are interwoven throughout our financial framework. It takes time to remove references to them and there remains a modicum of inertia among market participants in moving away from the Big Three or away from credit raters in general. But there has been a tangible change in momentum, with raters like Canada’s DBRS having already secured a large (majority) share of the U.S. residential mortgage-backed securities (RMBS) market — hardly a sign of “difficulty competing.” (WSJ May 2010)

Rather than being anxious about seeing immediate changes despite the lengthy history, and deeply embedded nature, of credit ratings, we urge the media to rather applaud the substantial regulatory improvements that have been made in respect of reducing reliance on ratings and heightening the integrity of the ratings process. We caution, however, that a material increase in the number of rating agencies leads to greater competition and not to higher quality ratings. More accurately, the readier the supply of ratings, the higher the inflation of ratings provided.


Notes:
(1) Aside from the 11 SEC approved NRSROs, there are already according to our calculations 108 other debt rating companies worldwide, 18 of which are affiliated in some way or other with one of the NRSROs.
(2) To visit submissions to the SEC, including our submission, on the credit rating reform proposals put forth in the Dodd-Frank Act, click here.