The most important and the most basic issue related to ratings and rating agencies has not been recognized or addressed in reforms announced so far. Here’s a new idea on a practical solution to address this most fundamental issue, which also addresses the conflict of interest issue that has received the most attention so far.

The Reforms

Ratings agencies have been criticized heavily by many for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been blamed for throwing fuel onto the fire of crises by belatedly and aggressively ratcheting down ratings. Numerous proposals have been put forward to reform the rating process to avoid these issues.

The US Congress, after resolving the differences between the House and Senate versions last week, is on the path to pass a sweeping financial regulatory reform bill aimed at increasing oversight and regulation of the US financial system. Among the issues addressed is reform of credit rating agencies. However, the compromise bill avoids most of the stronger proposals. The bill directs SEC to conduct a two-year study to determine if a board overseen by SEC should be setup to help pick which firms rate asset backed securities (the Senate version of the bill had required such a regulatory board). The bill also adopted a softer version of proposed liability provision than was in the house version of the bill (investors must show a company “knowingly or recklessly” failed to conduct a “reasonable” investigation before issuing a rating). The compromises are better than the extreme versions of proposals even though it means that the proposed regulations may not do much to change how the agencies operate.

Earlier, in mid April, SEC made some changes. In the update of Regulation AB, it eliminated the involvement of rating agencies in the shelf registration process by removing the requirement that the ABS be rated investment grade. This clearly has no impact on the rating process.

SEC also promulgated the Rule 17g-5, which went into effect on June 2, to address perceived conflicts of interest with issuer-paid ratings provided by nationally recognized statistical rating organizations (“NRSROs”). The rule aims to increase the number of ratings and promote unsolicited ratings for structured finance products. To achieve this goal, the rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies. The concept is good, but if implementation means rating agencies will have to share all information with other agencies, they may have less incentive to dig deeper and find more data.

None of these changes are radical overhauls or even proportionate to the amount of Calpers has sued the three major bond rating agencies for $1 billion in losses it said were caused by Markets reacted violently to the cuts as investors worried about the safety of the debt of these countries, and contagion spread from Greece to other countries. Stock markets tumbled worldwide, and bond and currency markets had big moves and became very volatile.

Another way ratings impact markets is via the feedback loop between the markets and ratings through portfolios tied to indexes mandating certain holdings of particular debt. For example, the Barclays Euro Government Bond Index includes Greek debt as 4% of index, but only if the bonds maintain a certain credit quality based on lower of the rating from S&P and Moody’s. Greece had been 4% of that index but was excluded starting May 1, due to S&P’s downgrade. That in turn likely forced selling from investors tracking that index.

Critics assailed rating firms for fueling woe in Europe and Europeans criticized debt-rating agencies, accusing them of spooking the markets and worsening the plight of financially stretched governments such as Greece, struggling with heavy debt loads.

There are several other examples where a company needing to raise more debt in capital markets finds it cannot do so, or not at a reasonable cost, once it has been downgraded even while it was attempting to raise capital to improve its financial situation. The downgrade increases cost of financing as investors demand more yield reflecting lower rating. The downgrade may also result in existing investors having to sell holdings, further increasing the yields in the market. It can become a vicious circle increasing the likelihood of default. The downgrade reflects rating agency’s opinion of the outcome, but it also becomes a causal factor in determining that outcome. The rating agencies in effect become the judge, jury, and the hangman for the company.

The Real Problem That Has Not Been Recognized

In the current system, the rating agencies’ opinion can become a causal factor in making that opinion become reality. Time and again, in structured products and otherwise, it has been clear that the rating agencies are not infallible in their judgment, and do not have any special powers of predicting future. Their failures in predicting subprime mortgage performance have been appalling. But even if you look at the forecasts of defaults in corporate bonds, the predictions do not match the actual outcome, and the predictions themselves change over time, as they should.

So, if ratings are heavily embedded in the system and are needed, and yet rating agencies are not smarter than everybody else, and if they do not have special predictive powers about the future, how do we avoid giving their subjective opinions so much importance and extraordinary power?

The answer lies in recognizing the real problem – one that has not been addressed in any of the proposals so far. The real problem is that the rating agencies are combining two roles into one. First role is to provide a rating based on statistical analysis and past performance of the assets – remember that SR in NRSROs stands for Statistical Ratings. The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. At the same time, it leaves rating agencies open to criticism if they do not act and the feared worse outcome becomes reality before their downgrade. This also allows subjectivity and flexibility in ratings process that creates perceived conflicts of interest in issuer paid ratings.

The Solution

The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events, and cannot be blamed for not downgrading sooner. This role will be limited to those approved as NRSROs.

The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as Informational Ratings without any legal or official role impacting investor charters, debt covenants, etc, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started - as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.

The information provided to NRSROs should be made available to all NRSROs and other non-NRSRO rating agencies, in a manner similar to password-protected website required under SEC Rule 17g-5. However, to promote competition and improve quality, the other rating agencies should be free to gather more information and not have to share it with others.

The conflict of issuer paid rating could be avoided if issuers were required to pay a fixed fee based on deal type (maybe to a group set up by the SEC or an industry association for that purpose) which would be divided between all NRSRO raters informing issuers of their decision to rate the deal after the issuers post the information on the password-protected website for credit raters. This will avoid ratings-shopping by issuers even though the agencies will be indirectly paid by the issuers. The NRSRO Rating will be provided to investors without any charge. The NRSROs will only provide the current rating, along with disclosing their rating methodology to investors. They will not provide any opinions or qualitative information.

For more qualitative information and opinions, investors will look to the Informational Ratings and more details from research providers (including NRSROs and non-NRSROs). This will be paid for by the investors looking for enhanced information and research. This will be the main source of income for credit raters and will incentivize them to compete with others for investor subscriptions and produce quality results.

Separating the two roles avoids the issues of rating agencies precipitating events if they act or facing criticism if they do not. It avoids the perception of conflict from issuer-paid ratings, by allocating costs between the issuer and the investors. It also preserves the role of rating agencies where its needed, while encouraging the investors to do more work on their own and look for third party unbiased research and opinion.