Rating fin instruments

Rating Financial Instruments –
A Proposal
The Double-Blind Approach

Author: Stephen O'Malley South Salem, NY All Rights Reserved
Background
• Many feel the financial collapse of 2008
and 2009 was compounded by the “loose”
process used to rate investment bonds
and other financial “instruments”.
• Seemingly risky investments were given A,
AA or AAA ratings from one of the big
agencies – Standard & Poor, Moody’s,
Fitch and DBRS.

Ratings Process Past & Present
• A long time ago the only way an
investment rating agency made money
was from the fees they collected from
investors.
• Sometime on the 1970s the model was
changed and the security issuers began
paying the agencies rating their products.
This was a recipe for problems.

Ratings Rationale
• Investment vehicles were often rated based on
the past performance of similar investments from
the same issuer – regardless of the degree of
leverage or other important factors.
• There was a general consensus that if the rating
agency was too conservative with the rating they
gave to an investment product they would not
get any repeat business from that issuer.

An Alternative Rating Scenario
• A more equitable and much less suspect
process could be modeled after the way new
pharmaceuticals are tested – using a double-
blind technique.
• Double-blind testing is used to test new drug to
eliminate any “placebo” affect from influencing
the outcome of the trial.

Double-Blind Rating Process
• In my proposal the issue would not know which
rating agency was going to assess their financial
product (first-blind)
• During the assessment process the rating
agency would not know the who the creator of
the financial product was. It would be the
government commission to only provide
quantitative data to the rating agency (second-
blind).

Double-Blind Rating Process Detail
• In this process the issuer would file an application with a
government commission like the SEC to have a new
investment product rated.
• The government commission would collect a fee for
taking and processing this application. The fee would
include the cost of paying the rating agency.
• The government commission would then go to select
one of the rating agencies registered with them at
random to investigate and assign a rating to the new
product.

Double-Blind Rating Process Detail
- continued
• The rating assigned by the agency would be kept secret
and only be provided back to the government
commission. The rating agency would then be paid by
the government commission from the fee they collected
when the issuer applied for the rating.
• The government commission would then release the
rating assignment to the issuer without ever revealing
which rating agency was used to evaluate their new
product.

Assumptions
• In order for this double-blind rating system to
work the following would be required;
– The direct rating of a financial instrument by a rating
agency would have to be banned. – i.e.. It would be
illegal or a regulatory violation for an investment
issuer to approach a rating agency for an opinion
about one of their products.
– That each registered rating agency would be able to
investigate and rate a new product in such a way that
was “invisible” to the issuer and the entire financial
community.

Assumption - continued
– That the government commission will be able to keep
secret which rating agency is chosen to grade a
investment product.
– That the government commission will hide (protect)
the identify of the agency assigned to rate a product.
– It would be an ethical and legal violation for an
employee of the government commission involved
with the ratings process to divulge any details on who
evaluated a particular product.

Assumptions – continued 2
• It would be a violation for a rating agency to contact or
divulge what financial products they are or have rated –
under the double-blind process.
• Some type of appeals process would be used if an
issuer wanted to dispute an assigned rating where, for a
fee, the investment product run through the evaluation
process again but not sent to the same rating agency. If
a different rating was assigned under the appeal the
government commission would select a tie-breaker.
• All requests for information about investment ratings
from third parties would best be handled by the
government commission.

Process Flow

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