An Open Source Alternative to No Bid Contracts

At Muniland, Cate Long reports that the US Treasury Department’s Office of the Comptroller of the Currency (OCC) awarded Municipal Market Advisors (MMA) a contract to evaluate the risk of municipal bond holdings by banks it regulates.  OCC did not find any credible alternatives and thus is awarding the contract to MMA on a no-bid basis.  Quoting at length from Cate’s excellent blog post:

So federal regulators, who can no longer use credit ratings for evaluations of the municipal bond holdings of the commercial banks that they regulate, just gave a no bid contract to MMA, a relatively small firm with four principals. In essence the OCC will be substituting the opinions of MMA for those of the credit ratings agencies. Federally chartered banks held $363 billion of municipal securities as of 4th quarter 2012 according to the Federal Reserve ... The federal bank regulator will essentially be substituting the work of credit rating agencies, which issue over 1 million individual municipal ratings, with “research” from a small private shop. Is this wise? I think restricting themselves to such limited information is short-sighted given that muniland has over 80,000 issuers with $3.7 trillion of municipal debt outstanding. High quality credit analysis for even the debt of 50 states requires a shop bigger than MMA. Let alone all the other issuers. … Of course all the folks at MMA are nice, informed market professionals. But this process of hiring independent municipal research is ridiculous. No bid contracts have no place in our new, more transparent, post Dodd-Frank regulatory framework. The municipal bond market is facing its toughest challenges since the Great Depression and this BPD/OCC process needs more public input and openness.

As I will discuss at Tuesday’s SEC Credit Ratings Roundtable, there is a better alternative to this kind of arrangement. For almost 50 years, academics have been churning out corporate default models.  This modeling effort could be extended to structured and government bonds.  If the modeling data and software were fully open, these academic tools could undergo rapid, iterative improvements through a process of mass collaboration:  like Wikipedia or Linux.  If the SEC were to create a standards board for open source credit models, a group of experts would be empowered to separate the wheat from the chaff among these open source products. Regulators could further encourage the development of such tools by allowing results of certified models to be used in lieu of ratings as a credit-worthiness standard – meeting the spirit of Dodd-Frank Section 939A.  I make this argument at greater length here.

What should supplement or replace ratings?  Confidential, non-reproducible findings from a proprietary vendor, or transparent tools developed using academic research protocols and benefiting from peer review? I think the answer is clear.