In The Blogs

Eating Your Own Dog Food

| Tue Sep. 29, 2009 9:32 AM PDT

Wall Street has a demonstrated aptitude for bundling up and securitizing pretty much anything: mortgages, credit card debt, parking meter collections, naked swaps, bundles of bundles, etc. etc. So why not put this ability to good use as a way of motivating ratings agencies to care about the accuracy of their ratings? A reader emails with this elegant suggestion:

Require them to sell collateralized rating obligations. The idea is that they will bundle tranches of ratings together into a form of a put. If the tranche of, say, AAA ratings fail at a rate greater than whatever the published risk of default of the class is, they will be forced to pay a contracted amount to the purchasers.

I like it! There's no income stream associated with ratings, which is a problem, but surely one that Wall Street can solve. Instead of paying a fee for getting their securities rated, maybe issuers should instead be required to set aside 0.1% of the income stream from each of their products to be bundled into a Ratings Backed Security. Agencies would be allowed to sell half the RBS immediately, but would have to hold on to the other half for a set period of time related to the maturity period of the underlying securities.

Or something. Details are left as an exercise for the reader. But I like the out-of-the-box thinking here!

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Comments

I like the idea, but

Submitted by alex (not verified) on Tue Sep. 29, 2009 11:54 AM PDT.

I like the idea, but unfortunately it doesn't seem much different than selling CDS's. As a form of insurance, CDS sellers certainly had an incentive to independently evaluate risks. Can you say AIG?

Pay them in the bonds they rate

Submitted by FearItself (not verified) on Tue Sep. 29, 2009 1:02 PM PDT.

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solution

What if the ratings agencies were paid with the bonds they rated, instead of cash? The trick is they would have to prorate the amounts; one share of AAA-rated bond would equal 150% of its face value, AA 125%, A 100%, and on down. That would discourage them from dealing out the high ratings willy nilly. Oh, and they'd also be obliged to hold the bonds to maturity.

No, I don't know where they would get cash to pay their employees, but I also don't care. They'll figure something out.

Elegant idea

Submitted by Travis2 (not verified) on Tue Sep. 29, 2009 2:55 PM PDT.

It's a nice idea. My first objection would be de-linking these bonds from the business cycle. That is, AAA instruments have a specified rate of default, but that rate of default will vary depending on the distance to the next recession.

Still, it's nifty. I especially like the bundling of different ratings into tranches. That way, the issuers dos not have to worry about large payouts for individual flame-outs and buggy-whip manufacturers who have suddenly reached the end of their markets.

I had one suggestion re how

Submitted by Anonymous (not verified) on Wed Sep. 30, 2009 8:09 AM PDT.

I had one suggestion re how to regulate rating agencies. Require the entity selling the rated bond or product to also provide information regarding prior ratings by the agency and the payment histories on the rated products. I'm assuming that this information isn't really available so that a buyer just sees an AAA rating without any context. At the risk of being naive, the possibility of buyers rejecting a bond issue because the rating agency has a history of giving AAA ratings to junk might cause the agencies to be a little more rigorous.

Amazing

Submitted by daCascadian (not verified) on Wed Sep. 30, 2009 10:59 AM PDT.

That's what it is, amazing. The Looneybury hasn't showed up to let us all know how pissed off he is that there is sane discussion about this topic. I wonder how long that will last.

“Any plan that relies on the sheep to negotiate with the wolves is doomed to failure.” - Lester Dyke

CDS ratings have been accurate

Submitted by James A. Donald (not verified) on Thu Oct. 1, 2009 8:08 PM PDT.

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solution

It seems to me that until November 2005, it was at least somewhat plausible that the official AAA ratings were not total lies. A rising discrepancy between the CDS market at the ratings was met by AIG, with implicit government guarantee, trying to bring the CDS market into agreement with official ratings. In November 2005, a gigantic horde of cynics with a great deal of money overwhelmed AIG's ability and willingness to rig the market, and thereafter, CDS prices correctly predicted looming disaster.

The major reason the government wants to "regulate" the CDS market is that since 2005, its ratings have been a lot more accurate than those of government blessed ratings agencies, and the government does not like the implicit criticism.

When the rating-organization

Submitted by paulw (not verified) on Fri Oct. 2, 2009 8:24 AM PDT.

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solution

When the rating-organization scam first came out, I suggested that the companies have their fees paid in the security they were rating, with a hold-to-maturity requirement. They could meet cash-flow requirements by borrowing against future earnings. And, of course, once the scheme had been in place for a few years the stream of sales for such securities as survived would provide cash flow.

This is the same kind of thing as changing CEO compensation to longterm stock grants that vest only after the longterm effects of a policy are known. (Although for that I'd like to see a provision that the CEO has to exercise options even if they're underwater...)