Wednesday, August 19, 2009

Alice Schroeder: Debt Raters Have No Place in Brave New World

It boggles the mind that the ratings companies are getting what amounts to a pass from Congress as it imposes wholesale repairs on other parts of our broken financial system. This is one of the places where big changes could matter most, so we will regret it if we waste this opportunity.

Many of the new financial regulations fall into the high- time category, but they also won't stop the never-ending boom- and-bust cycle. The three major assessors -- Standard & Poor's, Moody's Investors Service, and Fitch Ratings -- are different. If they didn't exist, the market would never invent a system that lets securities issuers give secret information to their paid agent to publish a widely relied-on rating for which the rating company has no legal liability. Even when the opinion isn't timely and, as so often happens, is dreadfully wrong.

It's unfortunate that the proposed changes tinker around the edges and take for granted most of this status quo. We shouldn't sit by and let this happen without objecting loud and clear and proposing real alternatives.

Let's consider how bad the situation really is by using an analogy. Ratings worked like the ancient Roman Catholic practice of indulgences, in which professional "pardoners" sold certificates to sinners as recognition that their penance had washed them free of sin.

Indulgence Peddlers

Anyone with a license to sell get-out-of-hell-free cards will quickly start acting as though they have one of their own. Sure enough, the pardoners went wild peddling indulgences and before long, an outraged Martin Luther nailed his theses to the cathedral door. The Protestant Reformation was born.

It's hard to understand why there hasn't been a similar outrage fueling an overhaul of the ratings system. The bill pending in Congress is too timid even to switch to "user pays" instead of the issuer, which despite all the teeth-gnashing is actually a minor proposal that would have limited impact.

The ratings system shouldn't be so hard to fix. We have just three companies whose business model should never have been allowed to exist.

Plan A, therefore, is to pull the requirements for ratings out of loan covenants, investment guidelines, swap documentation, and collateral triggers. Allow lenders and insurers to demand from issuers the data they now give the ratings companies. Better yet, turn that data loose on the Internet and let the free market handle the rest.

Fame and Fortune

Wiki-raters, bloggers, ratings boutiques would quickly emerge to analyze their way to fame and fortune. This is where the world is headed anyway -- a barbell. At one end, cheapie analysis done on the fly by strivers; at the other end, deep research purchased by the deep-pocketed few.

The ratings companies are an impediment to this natural evolution of efficient capital markets. Without them, the markets may value securities more accurately, closer to real time, and without the obfuscation of torturous "negative outlooks." Sure, there probably still would be crackups and crashes, but how could it be any worse than what we have now?

I can already hear the howling against this proposal. It would make issuers disclose "proprietary competitive information" to organizations that haven't sworn the Super Secret Rating Company Oath of Silence. Issuer A would know what Issuer B isn't telling us in its financial statements, such as how much money it really makes.

Know Your Sins

That howling will be the main obstacle to this fundamental change. Remember, ratings companies are like the pardoners: They know your sins and tell you what is required to make them disappear, so that nobody else finds out.

If investors liked this idea, though, they could start implementing it anyway. They could start dismantling requirements to use ratings. The assessors insist their gradings are only "opinions" anyway. That's why they can't be sued for negligence.

Let's move on to Plan B, which admits the truth, that ratings aren't an opinion. They are a classic form of third- party insurance in which the issuer pays the rating company to insure the investor against loss. Specifically, a grading allows a paper pusher at a state pension fund to nod off to sleep at his desk, then say, "It was rated AAA the day before it went bankrupt," and avoid getting sued.

Under Plan B, therefore, we officially turn the ratings companies into insurers. On Day One of Plan B, they begin writing credit-default swaps. They charge a premium based on whatever their "opinions" tell them to charge. They pay up to the counterparty on default.

No Wiggle Room

There is no wiggle room in Plan B. As long as the insurer/raters are allowed to keep their oligopoly, they may not swap, hedge or reinsure away the risk. Their activities must be overseen by regulators of impeccable quality who never have worked for, and agree they never will work for, either a ratings company or Goldman Sachs Group Inc.

Plan B works by putting ratings-company skin in the game. But it is complicated, and it may be hard to find a regulator who hasn't worked for Goldman Sachs.

Also, because the assessors actually behaved as though their gradings were opinions, who would want to buy insurance from them now?

This is why I prefer Plan A, which is clean and uncomplicated, and relies on the market.

Either way, it's time for real change. It has been said in Washington that you never want a serious crisis to go to waste, so let's not waste this one. Here is how to fix the broken ratings system: Waste the ratings companies.