20 Jun If CRAs don’t want to make the necessary changes to bring about a fair, capital-efficient structured finance market, there are next-generation Fintech solutions on the horizon that don’t demand six (or 10) BPS.

To Boomers, shave and a haircut, two bits brings back memories of Looney Tunes. It’s also the essence of what is wrong with structured finance credit ratings.

Wait, do structured finance credit ratings still need fixing?

Many assume the answer is “no” because the causes of the GFC are no longer being debated in the media or Congress. That’s reasonable only if you believe under-regulation of the credit rating agencies (CRAs) was the main cause. Meanwhile, the basic problem goes unfixed—the pervasive, patently untrue belief that structured rating analysis is simply corporate credit analysis with a twist.

Structured securities are engineered products, not corporations. All material operational and financial details are not simply executed in the ordinary course of business. They are an integral part of the transaction blueprint and must be followed to the letter. Very little is left to chance and discretion. The critical unknownis the realizable value of the collateral.

Over time the uncertainty goes away as the pool pays down, making it possible to value structured securities very precisely in real-time. Contrast this with corporate debt, where the source of repayment is the corporation, but its value is no more certain at termination than at origination—and in any case is irrelevant. The two paradigms could not be more different.

Structured ratings as glorified haircuts

THE SHAVE: A static pool of receivables is sliced from the seller’s balance sheet.

THE HAIRCUT: Legally, the cash flows belong to a new balance sheet. The intrinsic value of securities in the new capital structure is uncertain, but made more certain by CRAs, which, effectively, adjust the collateral cash flows to account for credit risk before assigning a rating.

THE SIX BPS: If the transaction goes to market, the agency collects its fee from issuance proceeds. (As a Moody’s structured analyst in the ‘90s, fees were 3.5 BPS times the issued amount. There was nothing to negotiate, but CRA competition focused more on getting it right, less on corporate profitability. Fees today are negotiated but average around 6 BPS.)

The above doesn’t do justice to the alchemy of CRA structured methodologies and criteria—if you want to know, there are literally hundreds—but it pretty well explains the phenomenon of rating shopping.

If CRAs are just selling haircuts, why not shop for the one that suits me best?

Of course, CRAs will tell you they are selling standards. But, for the rating to represent a standard, it should reflect the fully-valued option-adjusted expected security outcome based on all data available to project cash flows arriving early, late or not at all.

Leave discounting to the market. Structured ratings that start by shading and tweaking cost the public dearly in the Crisis and are also costly in normal times. Real money—to fuel economic growth and productivity—vanishes with the haircut. In the old days of corporate finance, we said haircutting was “prudent” and “conservative.” In the brave, no-longer-new world of structured finance, arbitrary haircuts are just plain old robbing Peter to pay Paul.

America has bought off on the notion that tighter regulation restored financial stability, but in reality structured finance can still set Paul up to rob Peter and make it stick. So long as the market follows ratings, and the ratings are made up of ad hoc measures that don’t calibrate to a non-negotiable scale of performance, significant quantities of capital that could be reinvested in infrastructure, jobs and education, will continue to leak out of the system.

Time to insist on standards, not haircuts.

In Australia, apparently, the words are Shave and a haircut,drop dead. In Mexico,Chinga tu madre, cabrón. If CRAs don’t want to make the necessary changes to bring about a fair, capital-efficient structured finance market, there are next-generation Fintech solutions on the horizon that don’t demand six BPS.