The Securities and Exchange Commission of La Mancha

I’ve long been a critic of the ridiculous regime created by NRSRO legislation, that is, the Rating Agencies, or really, S&P, Moody’s, and Fitch.  There are so many problems from top to bottom, left to right that I’m not even going to begin to list them here.  I will, however, quote what I think is a rather eloquent description of the core problem from a man far smarter than I: David Rowe in a post he wrote on the Kamakura Corporation blog (emphasis mine, as usual).

Currently, the US Securities and Exchange Commission (SEC) is soliciting comments on various proposals to reform the institutional framework of credit ratings. The supervisor wants to ensure effective ratings, as if there is some objective truth that can be discovered as long as the right incentives are in place. In fact, when dealing with innovative, highly complex and historically untested structures, no such objective truth exists. The perceived credit quality of such instruments can be as diverse as views on whether a given company’s shares are a buy or a sell. Imposing a one-size-fits-all rating scheme risks unrealistically homogenising market perceptions that should be highly diverse if adequate information for detailed analysis was widely available. Furthermore, it is just such homogenised perceptions that can lead to herd behaviour and major market dislocations when broadly shared expectations prove to be unfounded.

Trying to reform market structure in search of a non-existent objective measure of credit quality and associated risk amounts to a mission impossible. It is bound to bureaucratise and homogenise ratings, thereby creating an inflexible structure that is vulnerable to a systemic crisis. In fairness, the SEC is only doing what was mandated by the US Congress. Nevertheless, what should be done is to seek a framework that will make all the relevant data underlying such securities readily available in a standard format to a broad community of analysts.

Attacking the independence and objectivity of the ratings agencies due to their business model is easy, but it largely ignores the deeper problem Rowe describes above.  The ratings agency approach to credit analysis is inherently and impossibly broken, and efforts to reform it merely amount to tilting at windmills.

However, while hardly perfect – far from it – I think the equity model and the equity-research-centric approach currently adopted by the SEC would be largely instructive for how to reform the credit research industry.  A not insignificant amount of the information needed to analyze a firm’s credits is already included in the filings publicly-traded firms already make to the SEC.  Why not align the reporting requirements for debt and equity issuers?  Why not incentivize a movement to democratize the credit market just as the equity market was over the past 30 or so years?  Seeds of revolution (or rebellion, depending on your perspective) have long-since been planted with exchange-traded hybrid securities, ETNs, and a myriad of other products and services.

I realize the Herculean (if not downright Sisyphean) effort facing regulators with their current responsibilities from Dodd-Frank, but why not kill several giant birds with one stone instead of ignoring keeping the blinders on until the next inevitable crisis?

3 thoughts on “The Securities and Exchange Commission of La Mancha

  1. Pingback: Morning News: July 15, 2011 | Crossing Wall Street

  2. A little thought on the institutionalization of risk in the pursuit of “truth” in finance. http://nickgogerty.typepad.com/designing_better_futures/2009/06/var-explained.html

    A monopoly on truth in essence the ability to predict the future is a false belief and yet having a ratings based risk system at the BIS or national level is predicated upon this notion. Getting rid of the regulatory and statutory reliance on ratings would create uncertainty and inefficiency in the system leading to more small localized failure but might produce a more stable long term system. I will take small sporadic failure over large cataclysm any day.

    • The reason we have our current system and why there’s so much opposition to change is because so doing would represent a massive shock to the status quo. Pensions, endowments and all manner of institutional investors would have to re-work their mandates and investment staff/processes and *gasp* maybe have to do their own independent analysis or outsource it to new shops that would undoubtedly spring-up to meet the market need.

      I’d imagine eliminating the ratings-based system would also be a boon for the bond insurance industry, whatever’s left of it/new variations on the theme as issuers seek out help selling their various credits.

      Great comment, thanks!

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