What Buying a House and Structuring an Asset Backed Security Have in Common

When you buy a house, it's generally a good idea to get it inspected so you know if there are any expensive problems you might have to pay for after the deal closes. It's also a good idea to make sure that the person inspecting the house be independent, knowledgeable and perhaps most importantly objective -- not paid by or otherwise conflicted with the seller. Otherwise, they might overlook problems to make sure the deal goes through.

Asset backed securities (ABS) -- such as mortgage backed securities (MBSs), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and auction rate securities (ARSs) -- are also 'inspected' before they are sold to investors. The inspectors are Nationally Recognized Statistical Rating Organizations (NRSROs), and there are only a handful; Moody's, Fitch, and Standard & Poor's are the big three in the industry. So in both a housing transaction and an ABS deal, you rely on a third party to make sure the structure is sound.

The current status quo of the credit rating industry is that issuers hire the rating agencies. If they don't like a rating from one particular rating agency, they could just try another. For example, a recent deal linked to car loans was essentially denied the highest ratings from Moody's and Fitch (each citing the lack of investor protections) but had little problem obtaining the best possible rating from S&P. For a similar story, check out JP Morgan'srecentnon-agency RMBS deal (one of the first since the financial crisis).

The fact that issuers can shop around to receive the highest possible rating for a deal leaves little protection for investors andreduced value in the ratings received. By analogy, home inspections would have little value to potential buyers if the seller simply found an inspector willing to overlook flaws and not report objectively on the quality of the home. This issue has called into question the objectivity and reliability of credit ratings, but it is not clear what could replace them.

Recently, the SEC has been looking into how to improve the ratings systems to remove this conflict of interest (SIFMA has also investigated the issue). One proposal involves the government assigning rating agencies to particular ABS deals, rather than the issuer 'shopping around' between different agencies to get the best possible rating. This proposal has been criticized by Standard and Poor's, who claim that it "could create new conflicts." It is also unclear how the government could fairly allocate this business between the various ratings agencies, especially among relative newcomers such as Kroll, Egan-Jones, and DBRS.

Perhaps a better system would be for the SEC to require that ratings agencies disclose all ratings inquiries that it has received from ABS issuers. If they publicly disclosed who made the inquiry, whether a preliminary rating was assigned, and what that quoted rating was, then investors could determine whether the ratings reported by the issuer are fair and objective or if they represent the highest rating attainable in the open market.