What are Credit Ratings For?

Why do we have credit ratings? What are the main reasons they exist?

  • To provide profits to those that rate credit.
  • To provide credit standards for regulators and creditors (shame on you, do your homework) that can’t judge credit risk.
  • To allow debtors to easily issue debt; simplifying the pricing decisions of creditors.
  • Providing quantitative and qualitative analyses of new and existing debt issues, particularly small ones where it could not be economic for an asset manager to do his own analysis.

But credit ratings don’t exist for perfection. Rating agencies are encouraged to rate new structures and new collateral types, whether they have good data or not. Regulators need a rating for any asset they allow, and new asset classes should be viewed skeptically by analysts.

Applied to the Present

The standards proposed in the current finance reform bill don’t go far enough. The existing bill allows for ratings shopping. A better way to do it would be to allow the Credit Rating Agency Board to veto ratings of those that are too aggressive. The CRAB could set real standards for structured lending, and perhaps, push back against the continued downgrade in ratings standards. There would be competition to meet the standards of the CRAB, and of the originator at the same time.

Now this could eliminate securitization, and that is not all bad. Accounting rules should not affect economic actions. If accounting rules do affect economic actions, it means there was something wrong with either or both of the starting and ending accounting rules. And better that lenders keep the results of their lending decisions. In a levered economy, it is best for lenders to eat heir own cooking; it keeps things sane.

Securitization should only exist to the degree that parties that are more willing to take on illiquidity and credit risk do so, with fair compensation for the risk that they bear. There is no free lunch; just because there is a rating, it means you should believe it?

Caveat Emptor! should be on the wall of every house and business. Let the Buyer Beware! Regardless of how many government agencies or politicians pretend to protect you, you are your own best and most reliable defender.

Do your homework, and don’t buy complex instruments that you don’t understand. Don’t buy simple instruments of simple comanies that you don’t understand.

When rates are low, we struggle to find income. Be conservative if you can be. You are your own best defender.

Jasper - The Real Deal!

Risk Our Money Not Yours | Get 80% Off Any Account!

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write 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 still contribute to RealMoney, but I have 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 one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. 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.

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.

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.

Visit: The Aleph Blog

Be the first to comment

Leave a Reply

Your email address will not be published.


This site uses Akismet to reduce spam. Learn how your comment data is processed.