The Blame Game (II): Credit Rating Agencies are Rug Pee-ers

DUDE: Rug pee-ers did not do this.

       — The Big Lebowski (1998)

rug-peersProminent in the vast and ever-growing bestiary of people being blamed for the ongoing financial crisis are the credit rating agencies. It is their ongoing downgrades of structured paper — stuff on which they slapped triple-A ratings a few years ago during a fog of slavish stupidity — that has gutted the balance sheets of so many firms, causing them to keel over precipitously.

That’s the argument anyway. To be fair, it’s not new. People have been blaming credit ratings agencies for some time, and they have a point or two, but they’re still mostly wandering afield.

First, credit rating analysts are generally sweet people, but they’re not universally the sharpest tools in the financial shed. After all, when faced with the numbing work of weeks dawn-to-dusk building sterile spreadsheets that max out Microsoft Excel’s row/column counts, and still being bullied by jejune debt issuers, who among them wouldn’t have historically jumped over to Goldman/Morgan/CreditSuisse/UBS/etc., for 5-10x the salary? In other words, the people who hang around at agencies for a while tend toward numb lifers or newbies, neither of which you can expect to untangle the myriad nuances of the latest Constant Proportional Collateralized Mortgage Debt Obligation thingie sprung on them by lethally talented structured finance sorts. It just isn’t a fair fight.

Second, and somewhat more seriously, credit ratings agencies are  a government creation. Through a collection of overlapping indifferently updated regulations, they have ended up with a nifty oligopoly as Nationally Recognized Statistical
Ratings Organizations, which is not only a mouthful of opacity, but mighty profitable, as they are required if you want to rate issues, and competitors are kept out. It is why it’s more profitable for agencies to be paid by issuers, as opposed to having a subscription model: You’re kind of the DMV of the debt highways. Either way, the reason why the credit rating agency ratings are so seriously hooped is more about government stupidity than about credit rating agency malfeasance: Ratings have never really needed to be that good.

Third, and this is something most people seemingly don’t get, credit ratings change over time. Not only that, they change in ways that feed back into themselves. Consider the case of a company whose debt was triple-A at issue, but whose stock has now fallen. That makes it more difficult for the company to raise money and satisfy its liabilities, so you have to think about cutting the rating. But cut the rating and the stock will fall further, leading to more trouble raising money, leading to a lower rating, and … well, you get the picture. It’s a classic feedback loop, and there is diddly you can do about it. Pretending share prices don’t affect credit ratings is silly, but once you acknowledge it then you acknowledge the possibility of a death spiral as the two get into a low-altitude hug and your company slugs, liabilities last, into the ground.

Combine a government-created oligopoly, rapid financial innovation, negative feedback loops, and a horsepower gap between the issuer and rater, and what you have is a recipe for a big problem. And that is precisely what has happened. It must be obvious by now, however (to paraphrase The Big Lebowski), that the credit rating rug pee-ers are not the issue. The credit ratings agencies could hardly been better designed by government to provide structured finance issuers with cover for regulatory arbitrage.  And what’s what has happened, much to our collective financial pain.

So, do we reform the credit ratings agencies? Sure. Stop them from being paid by issuers. I’m fine with that. But why stop there? Why not reform them right out of existence? We don’t have a rating requirement elsewhere in financial markets, let alone in the real world. There are no government-certified equity or mutual fund ratings agencies, even less restaurant ratings agencies, or bicycles. So why do we have credit ratings agencies? The market does a better job of rating debt securities anyway, via this thing you have heard of called credit spreads. The only things that hurt spreads as de facto ratings agencies are that they are transparent, straightforward and inexpensive, all of which make them much less fun than doling out licensing largesse to new credit rating agencies.