Credit ratings still broken, experts say, offer a fix

McClatchy Washington BureauJuly 9, 2014 

— Despite the post-financial crisis focus on revamping Wall Street’s credit rating agencies, federal regulators have failed to fix the problems that contributed hugely to the economic meltdown, according to a paper released July 9th by the progressive-leaning Brookings Institution.

Credit ratings agencies still measure the likelihood that exotic securities will default in the same flawed ways that they have in the past, wrote Ann Rutledge, a New York expert in these types of securities, and Robert Litan, a senior fellow in Brookings’ Economic Studies Program.

Efforts to eliminate conflicts of interest created when the ratings agencies, the biggest of which are Moody’s Investor Service, Standard & Poor’s and Fitch Ratings, are paid by the very firms requesting the ratings have all but collapsed. But Rutledge and Litan argue that the “issuer pays” model was in effect for 40 years and “cannot explain the sudden explosion and subsequent collapse of the securitization market” over a few short years before the crisis hit.

Rather, they contend that a more fundamental problem is the absence of a single, numerical scale for measuring the risks of exotic securities.

Bundles of complex securities like those that plunged in value when the U.S. housing market crashed in 2007 and 2008 are still graded as if they were corporate bonds, drawing ratings such as AAA, AA and BBB based on the likelihood they will default.

That, however, “can be misleading, allowing sophisticated parties in the know to take advantage of naïve investors,” Rutledge and Litan wrote. They also can provide “a sense of false comfort for investors and policy makers, which contributed to the global financial crisis.”

“To complicate matters, no two credit rating agencies use the same benchmarks, which, in structured finance in particular, is equivalent to saying no two credit rating agencies count cash the same way, they said. “This not only violates the ‘law of one price,’ but the confusion for investors creates an opportunity for rating agencies to tamper with their own input scales undetected” to the benefit of preferred clients.”

However, if regulators could adopt “a public performance benchmark scale” for rating these securities, it “would narrow the sophistication gap between arrangers and investors, empowering the latter to conduct their own value analysis and ‘see through’ false ratings,’” Rutledge and Litan concluded.

“If we don’t have objective measures of credit risk,” Rutledge said in a phone interview, “then the only thing we have is psychology, and psychology works in the wrong way. When things slow down, then credit slows down and there’s not enough money. You can’t borrow.

“When you’re exuberant and can see nothing but blue skies, there’s too much lending . That’s why we need objective credit measures. We need yardsticks of performance.”

Email: ggordon@mcclatchydc.com; Twitter: @greggordon2.

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