Rating Agencies are Here to Stay, for Better or Worse

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Rating Agencies are Here to Stay, for Better or Worse

There’s one thing that is a little odd about me: occasionally as I am waking in the morning, something that I have been thinking about comes crashing in on me, and I get a moment of clarity where everything seems obvious for a complex question.

So to begin, I would like to say that I was utterly wrong in part 1 and part 2 of this series.  It won’t work.  Here’s why:

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When is it safest to buy high yield bonds — when spreads are tight, or when spreads are wide?  Of course, when spreads are wide.  When spreads are tight, it is risky to buy corporates.  But my method for allocating capital would do the reverse: it would force a lot of capital to be allocated when spreads are high, and little when spreads are low.  That’s the wrong way to do it.

Second, most bond defaults occur because the borrower chokes on an interest payment, not a principal payment.  If you can make the interest payments, under normal circumstances, you can refinance the principal.  That indicates that the risk of a bond will grow less than linearly with maturity.  It may even be flat.

The upshot of this, is that you would want to assign capital counter-cyclically if you could, but no one would go for that, it doesn’t fit human nature.  So maybe a compromise works where there is a fixed amount of capital assigned across the cycle, and not varying by maturity.  So how do you make adjustments for variable riskiness?

For corporate bonds that have a public stock trading, a contingent claims model can yield good results.  Egan-Jones does that, though many of the major raters have similar models, that they watch as a check on their fundamental reasoning.

But many bonds have no publicly traded equity to give them estimates of value and volatility.  Whether private corporates or securitized debts, there is no way to accurately estimate risks, unless you have a cash flow database of the underlying properties/assets, and aside from CMBS, that would be hard to get.

That brings us back to the rating agencies.  Much as they failed on rating novel types of debt that the regulators should not have allowed regulated entities to invest in, the rating agencies did a good job in rating seasoned corporate bonds, both private and public, incorporating private data to sharpen their estimates of creditworthiness.

I know that Dodd-Frank has required Federal Regulations to eliminate the use of credit ratings.  What have they substituted? Management judgement, simplistic statistical tests, nothing, and the ability to use quantitative rating schemes.  My view is this: there will be a series of scandals out of this, and there will be a return to the rating agencies, where human judgement takes in the factors that can’t be crunched into an equation.

Thus I return to my opinions expressed in: In Defense of the Rating Agencies – V (summary, and hopefully final). You can’t live with them, but you can’t live without them.

By David Merkel, CFA of alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.