(March 21, 2008) – Here’s a wild idea. Why don’t we come up new ratings agencies that actually tell you whether the company will be able to pay its debts in the future instead of the past? Read this article for an example of what I mean.
Although they look pretty good on a chart, rating changes issued after something has already happened (e.g., last week’s earnings figures) are of no use at all to investors.
Worse, they can do serious damage. Published ratings are often baked into loan documents in the form of covenants, or triggers, that lead to material, discontinuous changes in price or other terms for the borrower. These can sometimes trigger death spirals of covenant defaults, penalties and fees leading ultimately to insolvency.
It is a well-known rule of thumb in the complex adaptive systems literature that nonlinearity (step-up terms triggered by ratings changes) plus delayed feedback (publishing after the fact) equals chaotic change.
Institutions matter. We can do better than this.
JR
