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Open Source Ratings Are Needed To Break the Ratings Agency Oligopoly

photo of Michel Bauwens

Michel Bauwens
13th December 2012


The current credit rating system is fraught with problems: from lack of competition, accountability and transparency, to politicization, inconsistencies, and untimeliness. Private sector competition and transparency are needed to overcome these problems. The open-source approach, as implemented by the Public Sector Credit Framework, provides one possible solution to our current credit rating problems. Other solutions could be possible, if they offer sufficient degree of competition and transparency.

By Professor Krassimir Petrov:

“The current credit-ratings system is a complete farce that has caused damage in the trillions. It needs to be completely reformed into a more transparent, competitive system. An open-source approach presents a perfect solution.

Introduction

Credit ratings are of paramount importance in the economy. A rating evaluates the creditworthiness of the borrower. It provides the likelihood that the borrower will repay its debt, which describes the risk of default, and therefore the risk of the borrower and the loan. This risk determines the required return on the loan – the interest rate. Because investors cannot adequately determine the credit rating of a borrower, they rely on the ratings provided by credit ratings agencies. Good ratings allow for proper allocation of capital; while poor ratings result in overlending, misallocation of capital, and investor losses. Thus, proper credit ratings make capital markets efficient and underpin strong economic growth.

Sovereign credit ratings are especially important, because they affect the whole credit system in the economy. The sovereign is generally the government of an independent country like the United States, France, or Argentina. In general, the government is considered to be the lowest risk in the economy; in a sense, it represents the relative risk-free rate in the economy. Corporations and municipalities derive their risk from their national government. They are generally considered higher risk, because they “inherit” their government’s risk and add on top of that other economic and business risk. The whole credit structure of an economy is entirely built upon government credit. Its risk is based upon government risk. Any misjudgment of government risk propagates throughout the whole credit system with catastrophic results for the economy and horrific losses for the lenders.

Unfortunately, our modern credit rating system is fraught with problems that have already resulted in trillion-dollar losses and untold suffering by many nations. These problems extend to municipal, corporate, and structured-finance ratings. The system has proven to be a massive failure and needs to be entirely overhauled. The reform must necessarily provide for more transparency, more competition, and more flexibility. It also needs to address a large number of other problems outlined in the next section.

Problems of the Credit Rating System

The weaknesses of the current credit rating system are well-known and well-understood. It is not surprising that the ratings agencies have been heavily criticized for their spectacular failures in recent years. Triple-A ratings were assigned to large volumes of “toxic” mortgage-backed securities and collateralized debt obligations that ultimately lost value. A classic example of a corporate rating failure is that of Enron, where the ratings agencies did not downgrade the company until a few days before its bankruptcy. Equally spectacular were the triple-A monoline insurers like MBIA and AMBAC that went bankrupt or suffered belated multiple-notch downgrades during the global financial crisis. Finally, the spectacle surrounding the downgrade of the U.S. Government during the debt-ceiling crisis in 2011 made it all too clear that credit ratings agencies are politicized and incapable of prompt, decisive action. A deeper investigation offers other, more subtle problems. Here is a brief outline.

Problem 1 – Government Monopoly. The credit ratings agencies enjoy an extraordinary government monopoly that shields them from effective competition. With the creation of federal deposit insurance and the rise of mutual funds, the government began to regulate heavily the financial industry. It was necessary to limit risky exposures, including “risky” bonds. So, with the logical questions of “what is risky” and “who would determine it”, the government provided the exclusive privilege to a handful of “Nationally Recognized Statistical Rating Organizations” (NRSROs), thus shielding these corporations from competition. It created a de-facto cartel with long-lasting ramifications.

Problem 2 – Unaccountability. When ratings agencies make mistakes, they are not accountable for them. They simply don’t pay for their errors. They are not subject to free market forces either. They sell credit ratings and they charge for their product no matter how bad it is. In the free market, when the product is bad, the customer refuses to buy and switches to another provider. However, the exclusive privilege provided by the government excludes any competition; the consumer has no choice, no matter how bad the product is.

Problem 3 – Politicization. The rating process has become completely politicized. Because the government provides the “protection” (the privilege), the government can also take it away whenever the agency does not serve its interest. In essence, the master of the credit ratings agency is not the customer, but the government. This means that the government has extraordinary power and influence over the agencies, but government itself is driven by politics.

Problem 4 – Conflicts of Interest. The fact that the issuer pays for the rating provides a strong bias for a higher rating. Because the borrower pays, not the lender, the built-in incentive is to serve the interest of the borrower and to assign a better/higher credit rating. This clearly provides a conflict of interest, as the interest of the lender is not really protected and the lender has no recourse for a bad rating.

Problem 5 – Lack of Transparency. This really helps the agencies to promote their agenda as they see fit. They basically decide when to change the rating, how, and under what circumstances. Sometimes they “warn”, gauging the political winds and the potential for backlash. When needed, political favors or concessions are made to attract or retain large corporate clients.

Problem 6 – Inconsistent Methodologies. In scientific research and development, verification of methodology and replication of results is a required condition for proper scientific inquiry. In other words, consistent methodologies produce consistent results. This neatly ties in with the problem of transparency. Even though rating agencies have published their methodologies, these procedures lack rigorous validation and peer review. Also, agencies do not publish the minutes of their rating committees. One common source of inconsistency is the intentional use of too many factors, which allows raters to emphasize some credit drivers, while conveniently ignoring others. Thus, the agencies do not consistently follow their own methodologies. Naturally, inconsistent methodologies would lead to inconsistent ratings.

Problem 7 – Inconsistent Ratings. While major factors determining the rating of an entity are well-known and well-understood, such as the overall debt of a government, ZeroHedge has pinpointed a troubling inconsistency of BBB-rated countries that illustrates the problem in an article aptly-named “BBBeauty Is certainly In The Eye Of The BBBeholder”. The inconsistency is quite glaring, with Kazakhstan’s debt level of only 11% and Ireland’s – of 106% for similar credit ratings. Of course, government debt is not the only factor determining the rating, but clearly it is the dominant factor. Indeed, a variation in the factor is natural, but such a wide variation does not make common sense. It appears that these variations are more driven by politics and geopolitical concerns than by sound financial analysis.

Problem 8 – Untimely Downgrades. Downgrades are quite often late; and sometimes they come disastrously late, as many investors found out with the ratings of the credit derivative instruments. Most often, the agencies are very unwilling to downgrade, so that they don’t hurt their corporate clients. With sovereign ratings, political and geopolitical considerations delay the fateful decision to downgrade. Sometimes the delay comes from a fear of rocking the markets… And while the agencies habitually delay the downgrade, they sometimes delay the upgrade of many state and local governments. For example, as a result of the increased municipal bond defaults during the Great Depression, the agencies were too slow to incorporate improved credit performance of municipal debt after WWII – even half a century later.

Problem 9 – Insufficient Analysis. Sometimes the analysis is insufficient. Sometimes the responsible employees are overworked, too burdened with responsibilities, too slow to respond, and lacking sufficient time and energy. Sometimes the employee is young and inexperienced. And sometimes the outcome is politically pre-determined, so there is no need for proper analysis.

Problem 10 – Ignoring Maturity. Sovereign credit ratings should follow the example of corporate debt – each bond issue should have its own rating. Each rating should be based on maturity. To illustrate this important point, we can consider France, whose debt/GDP ratio is rapidly approaching 100%. While no one currently suggests or expects France to default within 1-3 years, many analysts believe that there is a much higher likelihood of default in the 10-15 year time frame. Thus, as an illustration, without suggesting that these rating are currently appropriate for France, maturity 0-5 years is rated “AAA”, maturity 5-10 is rated “AA”, and maturity 10-20 is rated “A”.

The Open Source Solution to Credit Ratings

The open-source movement has proven to be a powerful force in our modern technological world. It began in the software industry and rose to prominence with the success of Linux. It is steadily spreading in other areas. Open-Source Credit Rating Models provide a superior platform that effectively resolves all of the above problems. One leading example in the field is Public Sector Credit Solutions, which published in May 2012 an open-source sovereign and municipal rating tool called the Public Sector Credit Framework.

It is important to understand that, just like Linux, the open-source model does not immediately provide the “ultimate” solution. However, it is a dynamic, evolving rating system that is open to enhancements and modifications. Anyone can modify it, justify their enhancements, and observe the results. It is likely to branch, just like Linux, into many alternative and competitive versions. Some versions will prove better and will stand the test of time; others will fall behind and will be forgotten; still others might specialize in municipal, corporate, or structured credit. In such an open, transparent, and competitive environment, natural selection, adaptation, specialization, and survival of the fittest will determine the winners.

The open-source solution addresses adequately each one of the above concerns:

1. Open Competition. The open-source model breaks the status-quo cartel of the big three agencies. Anyone can enter the business and anyone can modify it. True, the monopoly is based entirely on government privilege, so open-source cannot break it by sheer legal force, but can still provide an option that the market can adopt, develop, and follow on its own.

2. Accountability. Competition forces accountability. The model has to work; it has to be good. If it is not, then a competitor will make a better product and promote its superiority. Open competition forces everyone to innovate. It keeps the competition honest – your competitor can always point to your flaws. It also provides the customer with the option to switch to a more accountable competitor. If competition forces accountability, then the customer enforces it!

3. Non-Political. Open-source is apolitical. Everyone can see what it is, how it works, and its final outcome. Transparency keeps the system out of politics. Whatever the politics might be, if the model is transparent, it delivers automatically its rating as a quantitative judgment, as a probability of default, just like SAT provides a score (number) to the student.

4. No Conflict of Interest. Open-source resolves immediately the problem of conflict of interest. The agency would follow an open methodology. Transparency will keep agencies honest. The customer/investor could run the model on his own and confirm the rating. The less conflicted competitor can point out the conflict. A whole new industry can grow to serve the needs of the investors, not of the issuers. That’s how it was many decades ago, and that’s how it should be. Open-source can facilitate and accelerate this process.

5. Transparency. By far, transparency is the biggest advantage of the open-source solution. It is the foundation that resolves other major problems of the current system. Transparency forces objectivity – everyone can see what the rating is and how we get it. It allows participants to pinpoint specific flaws in the system and improve on them. Transparency makes the rating automatic, thus keeping it out of politics. Automatic ratings also solves the problem with timeliness.

6. Consistent Methodology. Transparency exposes inconsistencies and enforces consistency. This does not mean that the methodology is static and does not evolve. It means that the same criteria for Mexico are applied to the U.S., just like the same criteria for Ireland are applied for Kazakhstan. As the methodology changes or improves, it is applied equally to everyone.

7. Consistent Ratings. Transparency ensures consistent methodology, which in turn ensures consistent ratings. If we use the same formula and the same inputs, we always get the same result. It is like McDonald’s using the same Big Mac recipe around the world to get the same burger. If the inputs and methodologies are consistent, then so is the rating.

8. Timely Downgrades. Transparency, consistency, and the use of data-driven software tools make the ratings automatic. When new economic data is published, the model can be re-run with immediate results. No more delay and procrastination. This also keeps politics out of the equation.

9. Sufficient Analysis. The open-source competition ensures that the model is optimal and that the analysis is adequate. If it is not adequate, then the model will be improved upon by competitors who will seize on the opportunity.

10. Incorporating Maturity. The Open Source Credit Model (developed by the PSCS) calculates a probability of default for all maturities and automatically assigns a rating for each maturity. Of course, that’s how every probability model works – probability can be calculated only for a specific period of time; without a time frame, probability is meaningless. Thus, the model automatically assigns ratings by maturity.

Conclusion

The current credit rating system is fraught with problems: from lack of competition, accountability and transparency, to politicization, inconsistencies, and untimeliness. Private sector competition and transparency are needed to overcome these problems. The open-source approach, as implemented by the Public Sector Credit Framework, provides one possible solution to our current credit rating problems. Other solutions could be possible, if they offer sufficient degree of competition and transparency.”

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