Suing or Regulating Rating Agencies

Dr. Ajay Shah has provided some very interesting comments on my earlier post about Private Sector Watchdogs: Reputational Capital and Financial Capital.

While agreeing with my post in so far as it relates to auditors, he has a different point of view with which I agree only partly. Ajay says

In contrast, the work of a credit rating agency is necessarily gray. The Agency merely gives you it's opinion that the Pr(default) is (say) 10%. After that, it cannot be held accountable whether default takes place or not, because these outcomes do not serve as a performance evaluation upon the probability statement.

Even auditors do not guarantee that they will pick up any fraud. They can sued only for negligence in their attempt to fix fraud. Some aspects of credit rating are actually close to audit. For example, in many ABS transactions, the market is relying on the rating agency for a lot of things. Only the rating agency sees the actual pool of car loans underlying an ABS. If the statements about the pool are wrong, the rating agency has some responsibility. Similarly in ABS/CDO deals, the investor probably relies on the rating agency even for the legal validity of the SPV structures and possibly even the CDS transactions underlying the transaction. They should be amenable to a negligence suit.

Ajay goes to say:

I feel that a credit rating should have the status of an `analyst report' on the stock market. It's the view of an individual. You may want to chat about it in a cocktail party, but for the rest, it should have no special status.

For individual companies, I agree. But for securitization and other complex structures, I am not so sure.

I fully agree with what Ajay has to say about regulatory use of ratings:

Given the lack of accountability of credit ratings or (worse) corporate governance ratings, I am a big skeptic on their role in public policy. When credit ratings go into pension fund regulation or (worse) Basle II, I think we are merely setting up an expensive diversion of resources with no clear accountability.

I agree. Today, there is the ability to have a completely open and objective rating based on the Merton model for large issuers. It should be possible for SEC or SEBI to say that if the distance to default (computed by an open source software) is less x standard deviations, it is investment grade and otherwise not. The only difficulty is that there is no Merton model for sovereigns. But then sovereign ratings by S&P and Moodys are also of dubious value as can be seen from the sovereign default data complied by the rating agencies themselves. In any case, the single best predictor of sovereign rating is per capita income and so these ratings are not really capturing default probability at all. I think the regulators should work on the equivalent of the Altman Z score for sovereigns. Since the performance of the rating agencies is not very high, achieving a comparable level of accuracy with a scoring model should be feasible. Once this is done, the rating agencies can be completely eliminated from all regulatory frameworks.

Posted at 10:41 am IST on Fri, 2 Dec 2005         permanent link

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