STOCK MARKET WATCH -- Wednesday, 26 December 2012

[Demeter]

2. Prof.Krassimir Petrov, econ., finance: US, Ireland, Bulgaria, Saudi Arabia, Bahrain, Taiwan, Macau

The current credit-ratings system is a complete farce that has caused damage in the trillions. It needs to be completely reformed into a more transparent, competitive system. An open-source approach presents a perfect solution.

Introduction

Credit ratings are of paramount importance in the economy. A rating evaluates the creditworthiness of the borrower. It provides the likelihood that the borrower will repay its debt, which describes the risk of default, and therefore the risk of the borrower and the loan. This risk determines the required return on the loan – the interest rate. Because investors cannot adequately determine the credit rating of a borrower, they rely on the ratings provided by credit ratings agencies. Good ratings allow for proper allocation of capital; while poor ratings result in overlending, misallocation of capital, and investor losses. Thus, proper credit ratings make capital markets efficient and underpin strong economic growth...Sovereign credit ratings are especially important, because they affect the whole credit system in the economy. The sovereign is generally the government of an independent country like the United States, France, or Argentina. In general, the government is considered to be the lowest risk in the economy; in a sense, it represents the relative risk-free rate in the economy. Corporations and municipalities derive their risk from their national government. They are generally considered higher risk, because they “inherit” their government’s risk and add on top of that other economic and business risk. The whole credit structure of an economy is entirely built upon government credit. Its risk is based upon government risk. Any misjudgment of government risk propagates throughout the whole credit system with catastrophic results for the economy and horrific losses for the lenders.

Unfortunately, our modern credit rating system is fraught with problems that have already resulted in trillion-dollar losses and untold suffering by many nations. These problems extend to municipal, corporate, and structured-finance ratings. The system has proven to be a massive failure and needs to be entirely overhauled. The reform must necessarily provide for more transparency, more competition, and more flexibility. It also needs to address a large number of other problems outlined in the next section.

Problems of the Credit Rating System

The weaknesses of the current credit rating system are well-known and well-understood. It is not surprising that the ratings agencies have been heavily criticized for their spectacular failures in recent years. Triple-A ratings were assigned to large volumes of “toxic” mortgage-backed securities and collateralized debt obligations that ultimately lost value. A classic example of a corporate rating failure is that of Enron, where the ratings agencies did not downgrade the company until a few days before its bankruptcy. Equally spectacular were the triple-A monoline insurers like MBIA and AMBAC that went bankrupt or suffered belated multiple-notch downgrades during the global financial crisis. Finally, the spectacle surrounding the downgrade of the U.S. Government during the debt-ceiling crisis in 2011 made it all too clear that credit ratings agencies are politicized and incapable of prompt, decisive action. A deeper investigation offers other, more subtle problems. Here is a brief outline.

Problem 1 – Government Monopoly.
Problem 2 – Unaccountability.
Problem 3 – Politicization.
Problem 4 – Conflicts of Interest.
Problem 5 – Lack of Transparency.
Problem 6 – Inconsistent Methodologies.
Problem 7 – Inconsistent Ratings.
Problem 8 – Untimely Downgrades.
Problem 9 – Insufficient Analysis.
Problem 10 – Ignoring Maturity.

The Open Source Solution to Credit Ratings

The open-source movement has proven to be a powerful force in our modern technological world. It began in the software industry and rose to prominence with the success of Linux. It is steadily spreading in other areas. Open-Source Credit Rating Models provide a superior platform that effectively resolves all of the above problems. One leading example in the field is Public Sector Credit Solutions, which published in May 2012 an open-source sovereign and municipal rating tool called the Public Sector Credit Framework...It is important to understand that, just like Linux, the open-source model does not immediately provide the “ultimate” solution. However, it is a dynamic, evolving rating system that is open to enhancements and modifications. Anyone can modify it, justify their enhancements, and observe the results. It is likely to branch, just like Linux, into many alternative and competitive versions. Some versions will prove better and will stand the test of time; others will fall behind and will be forgotten; still others might specialize in municipal, corporate, or structured credit. In such an open, transparent, and competitive environment, natural selection, adaptation, specialization, and survival of the fittest will determine the winners.

The open-source solution addresses adequately each one of the above concerns:



Conclusion

The current credit rating system is fraught with problems: from lack of competition, accountability and transparency, to politicization, inconsistencies, and untimeliness. Private sector competition and transparency are needed to overcome these problems. The open-source approach, as implemented by the Public Sector Credit Framework, provides one possible solution to our current credit rating problems. Other solutions could be possible, if they offer sufficient degree of competition and transparency.

DETAILS AT LINK

Read more at http://www.nakedcapitalism.com/2012/11/can-open-source-ratings-break-the-ratings-agency-oligopoly.html#BLFIrzCbhbMYdqAB.99