Wednesday, May 5, 2010

Bill Gross: I come not to bury the rating services, but to dismiss them

Pimco's Bill Gross on the rating agency follies:
In all of the hullabaloo over Goldman Sachs, a CQ analysis of the rating services – Moody’s, Standard & Poor’s and Fitch – has escaped front-page headlines. Not that a number of observers haven’t been on to them for a few years now, including yours truly. Back in July of 2007 some of you will remember my description of their role in the subprime crisis. “Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels and a ‘tramp stamp.’” Now, it seems, I was a little long on humor and a little short on the reality. Tramp stamp and hooker heels do not begin to describe the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the subprime craze, as well as reflecting the general deterioration of investment common sense during the past several decades. Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbors. The result has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don’t go bankrupt. Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.
For more lively prose, read his latest Investment Outlook. However, for a more thoughtful and self serving commentary, read Josh Rosner's Taming the Wild West:
While full elimination of the rating agencies may or may not be necessary or realistic, in my opinion we must reduce reliance on ratings and support a narrowing spread between price and value in the secondary market. To that end, the SEC should require that after the deal is sold, all data fields in the pre-issuance disclosures and material information about the loan level collateral in the pool should be updated and be similarly disclosed on a daily, or at least monthly, basis in an electronically manageable and standardized format. Regardless of the nature of the deal (private placement or registered) the data should be publicly disclosed to the loan level and all servicer advances to the pool shall be disclosed as such on a timely basis. Any subsequent repayments of servicer advances should also be reported in a clear manner.
And here's ex-Moody's guru Jerome Fons being interviewed on Rortybomb:
Imagine a central repository of ratings methods and data, accessible to all. Imagine a world of transparent data for all transactions and all securities. What we could then do is empower users, train them in the use of the methods. And evolve methods as needed. You could broadly democratized the process.

In this world you would do your own work, and it isn’t outsourced to clearly conflicted people. I think that’s where we’ll evolve to, but it’ll take a huge shift in our thinking and infrastructure.

The major ratings firms could improve transparency today by simply refusing to rate an obligation unless all relevant data is made public. I think that would be an important first step.
Pershing Square Capital Management chief William Ackman would like to see the Securities and Exchange Commission set up a research database, modeled on its EDGAR system for corporate filings.According to the story posted on FinAlternatives:
Ackman said he would also allow investors to post research on the database—with the caveats of full disclosure and no libel, those posts would be protected from liability.

“If we had a mechanism like that, where there’s a much freer exchange of ideas, it would lead to more accurate security prices,” he said. “It would be a great forum for the SEC to comb through to find companies they should focus their investigations on.”
Roger Ehrenberg on Information Arbitrage would go even further:
One of the unique aspects of the debt market is its mind-numbing diversity and dimensionality: maturity, amortization, optionality, collateral, seniority, etc. A "one size fits all" approach simply does not work for the bond market, and it is questionable as to whether a single entity has the intellectual horsepower and access to the resources necessary to effectively and efficiently analyze its range of securities. Large, seemingly intractable software problems have benefited from the massive collaboration available through the open source movement. This has been an effective method for not only addressing a core problem, but for keeping up-to-date and relevant as technology evolves. It has also been a vehicle for value-added service providers to build on top of these solutions (e.g. Red Hat/Linux, Lucid Imagination/Lucene, etc.) for specific use cases, providing needed service levels and documentation, etc. While not a panacea, the open source movement has effectively harnessed the world's intellectual capital and applied it to big problems relevant to a broad array of constituencies.

If an open source approach has worked so well in software, why not apply it to the ratings problem? Whether or not ratings should be required for institutional investors to buy certain securities is not the issue; the essential point is getting better transparency into and analysis of instruments constituting the investable universe. Imagine a university or a large institutional investor seeding the open source initiative by putting their own debt ratings models into the public domain and allowing others to contribute to its development. I can see a suite of open source libraries by type of instrument, with a new industry emerging to deliver additional analytics, data and recommendations on top of these libraries. There would need to be a Wikipedia-type board of curators, ensuring that additions to the libraries are sensible and increase the stock of intellectual capital. But I can't see why such an approach wouldn't address the biggest problems facing the ratings industry today.

Combining bond analysis and the open source movement could deliver:

  • Transparency;
  • Unbiased input;
  • Access to a global talent pool;
  • Opportunities for specialized applications to be delivered in tandem; and
  • Institutional-grade analytics and research available to all.

I haven't seen or heard of a better solution to the problem, and the problem certainly isn't going away. If we as a financial community are committed to such an approach, it is bound to be successful. Let's give it a shot.



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