Open source credit rating agencies are needed NOW!

Republished from Marc Joffe:

“Five years after the financial crisis, European and US regulators have yet to solve the problem of biased credit rating opinions. Moody’s downgrade of the UK’s credit rating and the recent US lawsuit against S&P remind us that credit ratings remain both consequential and controversial. More importantly, they are a byproduct of a broken industry hamstrung by obsolete regulation.

Rating agency regulation needs to evolve in order to encourage rather than stifle innovation. Just as TripAdvisor has disrupted the status quo for travel reviews, 21st century technologies can revolutionize the way that fixed income investors glean wisdom about bonds.

Rating agencies first found their way into US federal rulemaking in the wake of the Depression. Regulators decided that expert third-party evaluations were needed to ensure that banks were investing depositor funds wisely, especially since taxpayers started guaranteeing deposits under the auspices of the FDIC.

In the 1970s, after rating agencies adopted the issuer pays model, the federal government implemented NRSRO (Nationally Recognized Statistical Rating Organization) registration – albeit without oversight. Finally, the 2006 Credit Rating Agency Reform Act – passed in reaction to the controversy over Enron’s and WorldCom’s ratings – stiffened regulation of NRSROs.

To become a new NRSRO, a firm must submit 10 letters from Qualified Institutional Buyers stating that they have happily used the firm’s ratings for at least three years. This requirement is somewhat circular, because it is hard for a new rater to gain attention from institutional buyers without being an NRSRO.

Once a rating agency joins the NRSRO club it faces enormous compliance costs in terms of both employee training and reporting. Upstart Egan Jones recently found that the penalties for making errors on mandatory Securities and Exchange Commission (SEC) filings can be quite severe. The compliance burden actually favors the big three because they generate enough revenue to fully staff compliance units. New entrants often lack this luxury.

Further, Egan Jones and S&P share two characteristics that should raise an eyebrow: both downgraded the US and subsequently faced disciplinary action from the US government. Perhaps this helps explain why Moody’s chose to downgrade the UK while leaving the US at Aaa. The two countries have virtually identical central government net debt-to-GDP ratios, while the UK has significantly smaller central government deficits and is less subject to interest rate spikes due to the longer average maturity of its bond issues.

Expert opinions about bond risk can play an important social role. Since most people lack the time and expertise to thoroughly evaluate these instruments, delegating this task makes sense. Further, correct and credible expert opinions about fixed income securities promote a proper alignment of interest rates to risk, ensuring that our society’s scarce capital is effectively deployed. So rather than simply dismiss the ratings business, we should be trying to fix it.

What could a 21st Century rating industry look like? Today, computer models are available to rate all major classes of fixed income securities. In some cases, rating agencies use such models, but the workings of these models and the data entered into them are not fully disclosed. This creates opportunities to massage inputs and outputs, or to ignore potential improvements that produce commercially inconvenient results – as alleged in the Department of Justice’s complaint against S&P. Further, model results can be overridden by a rating committee, whose proceedings are kept secret.

A more modern alternative would leverage open source models with fully transparent inputs and outputs. As with Linux and Wikipedia, the software and data would be open to a worldwide peer review process, which could facilitate their rapid improvement. A number of examples for this radically open approach to credit modeling now exist including the National University of Singapore Risk Management Institute’s Credit Risk Initiative for corporate bonds and this author’s open source public sector credit framework for government bonds.

Regulators can accelerate the innovation process by empowering one or more certification boards to review and approve open source credit models. This way, rigorous modeling efforts can be differentiated from the dross that often plagues open source communities. A rough template for such a certification body is the World Wide Web Consortium that sets standards for HTML, XML and other internet technologies.

Well-meaning government regulations often have the negative unintended consequence of locking in outmoded ways of conducting business. A modern regulatory regime would empower mass collaboration technologies to improve credit rating performance.”

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