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Tuesday, Jan 24, 2017

How to create a credit-rating system you can’t game

The credit-rating industry has been one of the most successful fugitives from stricter regulation since the financial crisis. The companies’ failure to do their appointed jobs was as spectacular as that of the banks, and at the very center of the whole mess — yet the regulatory follow-through has been minimal.

The vital function that the companies failed to discharge should be rethought.

Robert Litan of the Brookings Institution (until recently, Litan was with Bloomberg Government) and Ann Rutledge of R&R Consulting (a firm of highly respected credit analysts) have just published a study for Brookings that says how this could be done. It’s one of the best things I’ve read on the unfinished post-crisis agenda.

Structured credits bundle different streams of payments in complex ways.

A standard corporate bond pays its owner what’s owed as long as the borrower is solvent — in this case, a ranking of borrowers in order of likelihood of default, measured on the familiar letter scale (AAA, AA, BBB and so forth), is a useful measure of risk.

Judging the risk of a structured credit is different, because rights to the underlying payments in different scenarios vary according to the design of the product’s various tranches.

The whole idea of structured finance is to repackage payments into safe and less safe instruments so that investors with different appetites for risk and return can be sold the blend they want.

The problem is: This additional complexity makes it easier to make mistakes. And sometimes those mistakes aren’t accidents.

In particular, the authors show that grading securities by rank order, rather than with an absolute measure such as expected reduction in yield, blurs vital information about the underlying financial engineering. This can give sophisticated investors, including the ones who did the engineering, an additional edge over everybody else. It also creates opportunities to game the system.

And if regulators continue to look at credit ratings for their own purposes and to tell investors to take them into account as well — which they do — financial risk can be systematically underestimated.

Rutledge and Litan propose a new yardstick for rating structured credits: a transparent cardinal scale measuring expected loss, as opposed to an ordinal ranking of distance from default. This should be overseen, they say, by a public regulator:

Given the market’s propensity to exploit information asymmetries, it is not surprising that a public benchmark scale has not yet materialized spontaneously to heal the broken market.

Nor is it likely to. Rating agencies for their part are no more likely now than before to volunteer to work together voluntarily to accommodate greater public scrutiny or diminish their own power.

As a classic public good, the structured credit scale needs public support and may need to be developed by one or more federal regulatory institutions that support the use of the structured credit scale in the regulatory landscape.

It’s an idea that should be pursued with urgency.

Clive Crook is a Bloomberg View columnist and a member of the Bloomberg View editorial board.