14 May Six FDAs or Six Feds?

“Imagine the pharmaceutical industry having six FDAs, all competing to approve drugs,” said Rob Dobilas, who founded Realpoint LLC, the credit-rating company bought by Morningstar Inc. in 2010, referring to the U.S. Food and Drug Administration. “Everyone would be dead.” See Matt Robinson, Bloomberg News, Ratings Shopping Revived.

Striking quote, but the analogy needs to be tweaked.

Many people confuse the credit quality on corporate bonds with that of securitizations and structured bonds. Corporate bonds are backed by the entire balance sheet of an operating company, with competing payment obligations and a portfolio of assets of different value and liquidity.

Structured bonds are backed by cash flows. Thus different ratings on the same security is tantamount to working in different currencies. Each currency is pegged to an exchange rate a.k.a. the credit rating scale. Thus, the valid comparison would be “imagine six different Feds” who control the money supply on their own terms. Everyone would be broke, except their patron clients. Oh, wait a minute.

And what’s the solution? Very simply, to adopt a unified numerical rating scale for structured. It would considerably curtail ratings shopping and limit the probability of another subprime bubble like the last one.