Should PIMCO and BlackRock be providing credit ratings on bonds?

February 16th, 2012 by

Why did the the three major credit agencies overate all those mortgage backed securities? There are two lines of thinking: 1) The credit agencies did not do a job anticipating a potential collapse in the housing market. or 2) They were beholden the people that paid their bills, their customers, the issuers of mortgages backed securities.

I think this chart that I found in the February 15th article authored by James Vichery reveals the truth. I want you to, for the moment, ignore the ratings on the horizontal access. Then, answer the following question: were the rating agencies able, with a fair degree of accuracy, to determine which mortgages were more risky and likely to default?

The answer is clear. The rating agencies were able differentiate between less risky and more risky mortgages. There was nothing wrong with their ability to analyze.

What they did wrong was incorrectly label the risks.

I am going to digress to a personal experience. Several friends and I went to a “poetry slam” event, think of it as a hip poetry contest. I was selected at random to judge. Ratings were public and on a one to ten scale. When I gave a poet a rating of 4, I was booed by my fellow audience members. While the rules said the scale was 1 – 10, everyone was actually grading on a 6 – 10 scale. It was considered impolite to give a rating below a six. I think the same thing happens with the rating agencies.

There is another factor to consider.

The rating agencies don’t invest based on their advice. They don’t lose business when they get it wrong. They have every reason to inflate the average rating.

On the other hand, PIMCO Funds and Blackrock are two organizations that do invest in the bond market they examine the credit worthiness of organizations every day, and invest based on those judgements. When they get it wrong, their clients leave them and go to someone that gets it right. Effectively, both BlackRock and PIMCO have ratings (although maybe not as structured as S&P) on bonds, they just don’t publish them. I would pay money to get these ratings.

Unfortunately, I don’t believe the regulators would like this. There would be potential for these two firms to profit by front running their rating changes (making an investment based on information available to them first). The SEC would not like that at all. On the other hand, I would be comfortable giving up a little potential profit in exchange for honest ratings.

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