Even unlicensed raters can be competent

Via Mahalonobis comes the results of a study on bond licensers. The SEC requires all public bonds to be rated by one of the four certified rating agencies: Standard & Poor's, Moody's, Fitch Ratings, and Dominion Bond Rating Service.

These companies are charged with acting as "information intermediaries" and improving the efficiency of securities markets by increasing the transparency of the securities themselves.

Those in support of the system say that the certification establishes a high standard of quality for bond ratings. Others—including members of Congress and, increasingly, representatives of the SEC—argue that the certification requirement serves as a barrier to entry for new competition. Moreover, critics of the existing system argue that because certified firms collect their fees from the companies being rated, there's a possible conflict of interest and a weakening of incentives to produce high-quality ratings. At issue is whether certified firms...should be criticized for failing to meet the basic needs of investors. After all, there are a number of non-certified bond-rating agencies that appear to do a better job of responding to the ups and downs of the bond market in real time—and which avoid any potential conflict of interest by collecting fees from investors, not debt issuers.

To determine the answer to this, Beaver and colleague Mark Soliman, assistant professor of accounting, along with Catherine Shakespeare of the University of Michigan Ross School of Business, compared the bond ratings of Moody's—a major certified rating agency—with those of a credible non-certified agency, Egan-Jones Ratings Co. (EJR)...The researchers examined the two company's ratings according to three criteria: correlation of their ratings with the stock market; correlation of their ratings with the bond market; and measuring which company led in predicting upswings and downswings in bond ratings.

The results were instructive: EJR's ratings more closely corresponded to both stock and bond market returns and appeared to be more timely and to lead Moody's ratings by a significant margin in reflecting positive market news. But Moody's did a better job of reflecting negative news, of explaining non-investment grade bond yields, and of predicting bond default.

This made sense given that there are two distinctly different clienteles for bond-rating information: large institutional investors, many of whom are bound by predetermined "prudent investor rules"; and investors who are more immediately "valuation-oriented" and take a more fluid approach to buying and selling bonds.

Here we have an unlicensed company helping guide a $1.3 trillion/year financial market, and doing so as effectively as the government-licensed alternative. Each fills a different niche, so their results are not directly comparable, but its still worth noting that the unlicensed business is doing a competent job. Which is not surprising - otherwise they'd go out of business. The real surprise in this case is that the regulators are actually realizing the effects of their licensing rules.

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I worked on a lot of ABS

I worked on a lot of ABS transactions and found S&P, Moody's and Fitch to be a little on the slow side, but very fair and definately accurate. Typically, the career path of rating agency analysts is to join investment banks after a few years with the both the relationships and knowledge of how to "work" the rating agencies.

I can't speak for the other two, but S&P's analysts consistently rated Enron's bonds as junk even thought the hordes kept buying them.