I agree with the gist of Paul Krugman’s column today, primarily devoted to berating some of the most notable culprits in the ongoing financial crisis, the credit rating agencies:
When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.
No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.
What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.
However, it has an omission so glaring it reminds me of Michael Powell’s great film, The Red Shoes. If you’ve never seen it, by all means do so.
It’s a story of ballet and the relationships among a prima ballerina, a demanding impresario, and a young composer. At the end of the movie, the ballerina takes her own life but the performance goes on, her red shoes taking her place on the stage. The shoes are there but the ballerina is not.
To be consistent with the Basel Committee on Banking Supervision and SEC regulations, for any financial instrument to be sold in the United States it must first be rated and not just by any old ratings agency. There are only three “Nationally Recognized Statistical Rating Organizations” in the United States: Moody’s, Standard & Poors, and Fitch. One of these companies must rate it or the instrument can’t be sold. That gives these three institutions enormous power and wealth and it’s a subsidy. The regulations create the power and wealth. Without the blessing of the SEC these ratings agencies would be much, much less important and much, much poorer.
Mentioning the influence of the ratings agencies without mentioning that the influence is granted by the federal government is like the shoes without the ballerina, a surreal sight in which something important is missing.
Dr. Krugman mentions one possible remedy for the conflict of interests between the ratings agencies and the companies they’re rating:
An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University. They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.
He implicitly rejects the obvious solution: removing the rating requirement. Caveat emptor.
Another possible solution would be to open the field: any agency meeting certain published criteria would be eligible for recognition as nationally recognized.
A third solution would be to compel the ratings agencies to put up a bond for every instrument that they rate of a given percentage of the complete value of the instrument. The percentage would be on a sliding scale with junk requiring the lowest bond and AAA the highest.
Basically, I think the ratings agencies need a lot more skin in the game.
Caveat emptor should encourage the buyer to get more information on a transaction. The issuing firm get’s to decide who rates their products? That’s not classic caveat emptor.
Interestingly, three of the six doctrines Krguman has espoused are about fixing caveat emptor. He says the problem is that the buyers are being deceived by the sellers (predation), the nature of the transaction is concealed from the buyer (opacity), and the buyer and sellers are not exercising independent judgment since they are in the same financial insitution (size). This is somewhat of a simiplification because the problem of opacity and size also impact the effectiveness of regulation.
But I don’t completely buy into Krugman’s framework of seller=bad, buyer=good. Paulson & Co. was a buyer. Most panics are the result of buyers buying too high, and either not seeing the collapse or intending to get out first. I’m not sure I’m interested in protecting the buyer, as much as the economy at large, and perhaps public funds invested in the market.
I’ll suggest another option for the ratings agencies. They appear to be operating as chartered institutions for government purposes, like British banks. We could strengthen the poltical ties between those in power and the rating agencies, so that poor performance by the rating agencies, reflects poorly on the political party in power, which can then be voted out.
What I mean by the first alternative is to abandon the sanctioned rating system entirely. Buyers should assume that everything is junk.
When regulatory capture and its analogs are so manifest, I see no way that going to a public/private hybrid for ratings or making the ratings fully the work of a government bureau will be an improvement. Are we that confident in the probity of FNMA, FHLMC, and the SEC?
Dave, on the first point I was mainly reacting to Krugman’s assertion that the seller picks the rating agency. I don’t like the sound of that at all. I don’t see how a rating agency can be credible without independence. I think that needs to be changed.
On the second point, I am not seriously suggesting that we strengthen the public/private hybrids, but if that is what we will have in one form or the other, then political accountability needs to be part of the equation. The discussion should move towards whether Moody’s is affiliated with a certain parties’ organization and if Moody’s screws up, that that party must suffer at the polls and more work given to S&P. Not really a smal “d” democratic idea, but it’s not the worst option.
With all the misinformation and misconceptions surrounding this whole sub-prime/CDO etc mess, the ratings agencies have not been spared.
Ratings agencies are key in my business, for syndicated structured finance products. Some observations:
The ratings agencies only provide opinions, and opinions based upon conditions and expectations at the time. These are not guarantees. If that’s what you want then buy T-Bills.
As a general rule raters are of course relatively more informed opinions. But when you consider that these were new products and that they were probably ill understood by the raters, one would have to ask what kind of fool would have believed the ratings. If memory serves, AIG was disproportionately hit vis a vis other investors. So who do we blame? The raters, or AIG??
[As an aside. It of course has been great fun, and it furthers the simple minded pop culture narrative, to blame this all on “27 year old MBA’s.” Not so. These exotic products were cooked up primarily by math and physics guys and – would you believe it – music majors and such. The theory was that these professions understood all the hard (math) and soft (music) related nuances of the statistical correlations and such. Ooops.]
So what do we do?
As for caveat emptor. I guess most people (except AIG) took that view wrt subprime CDO’s. But the truth is that the ratings agencies serve, and have well served, a valuable economic function in most asset classes. To shift that burden to issuers, or open it all up to the wild, wild west seems seductive, but economically dumb. Better would be to have a ratings moratorium until a new asset class has been around awhile.
Posting bonds? Not a chance. The raters don’t take principal positions. They don’t have the balance sheet; and if they did they might as well buy the bonds. They are not trading houses. But perhaps performance based (delayed?) comp? That sounds better. That’s skin in the game.
Opening up the field? You bet.
I can’t leave the subject without a straightforward query. With all the finger pointing at the raters, the trading and underwriting houses………where is the criticism of Fannie and Freddie, and their managers and overseers??
Heh….a credit default swap for the rating agencies ratings?
Steve V –
Yeah, I thought about that snark, too. 😉
Drew, you say that the ratings are useful, but are they useful from a public policy standpoint? Specifically, one of the reasons I support the bailouts of the banks was that so many of our government pension funds were invested in these AAA-rated mortgage-backed securities. Is getting a high rating protective enough of the public good? Or should public-purposed funds not be put at the risk of ‘just an opinion’? On the flip side, I think our state can probably trace most of its income over the last 10-15 years in its pension funds from investment returns. I don’t want to make things more difficult for the government, barring a preferred defined-benefits program.
My second question is whether your business experience is around rating of mortgage-backed securities. I can understand ratings based upon business plans or the financials of the bond-issuer; I am not sure what is being rated in the mortgage arena other then local, regional or national trends. My understanding is that the ratings agencies are not looking at the financials of the underlying mortgage or mortgage-holder, they are too small.
BTW/ Dave, under the department of nitpicks, the original Hans Christian Anderson story of the Red Shoes has the executioner cutting the dancer’s feet off as the irremovable shoes keep dancing. The image of the shoes still dancing in front of the church as the dancer tries to enter and repent her sins is arguably more disturbing than the movie. YMMV.
(We also watched Miyazaki’s Ponyo over the weekend, which is based upon the Little Mermaid. It was admirable, but not in the top tier of his stories. It does not all attempt to convey the pain of the Little Mermaid in the original, like many of the recaptured fairy tales)
PD –
The second paragraph of your post really gets to the crux of my point. The agencies actually have a fine track record in traditional asset classes. The issue is that these new asset classes were beyond their expertise.
Its great sport for politicians, blogites and such to portray them as idiots. But that says more about the commentators. These guys were supposed to rate instruments designed by the so called cutting edge rocket scientists. The raters had not a chance. No hope. (Or they would have been working at Goldman.) So I suppose they should have refused the assignment. But that’s hindsight.
In addition, a point I did not mention previously because it has the taint of political partisanship. But as I understand it the credit data on borrowers the ratings agencies receieved was simply false. The originators and syndicators, for political reasons, simply provided false or limited credit info. But no one wants to hear that. Easier to bash the raters.
For example: every single study perporting to identify redlining practices simply cites “loans given vs income” statistics. Balls. Ask any competant lender. After basic debt service to cash flow, the two crucial credit stats for any loan decision are history of repayment and loan to value. (skin in the game). These subprime loans had miserable stats on the latter. But that was doctored or deleted in reporting to the raters, as I understand it. There were politically driven agendas.
But its so much easier to blame everyone but the pols. And if the media stay silent, there is no hope of getting the message out. But look out, we have FHA loans as Fannie and Freddie II coming right on the heals of the last debacle.
Thanks Drew:
If the rating agencies cannot rate these instruments for whatever reason, they shouldn’t rate them. Or they should perhaps use a different rating system, so the consumers don’t mistake them for AAA-rated instruments that are rated conventionally.
But you tag me wrong for playing the blame game here. I think there is a lot to go around and starts with the speculators in the housing market, who are probably the normal neighbor you might see on a late night infomercial. But the rating agencies are one of the few entities in the whole story purporting to exercise independent judgment from buyer and seller. Where the rating agencies are being selected by the seller, that independence is compromised.
P.S. I have similar views on the alignment of interests by the players in the local housing market, including the appraisers, but time constraints prevent me from rambling.
” The originators and syndicators, for political reasons, ”
I think that the fact they were making billions had more to do with any politics. The originators were steering people into option ARMs since they made oodles more on them as originators. The alt-A loans were the loans of choice of the house flippers, especially in CA.
Otherwise, I think you are largely correct on the raters. The investment bankers were also hiring the people who rate the models for the ratings agencies. They learned that adding a small amount of CRE into the mix made the models turn out better results. I also think they need some personal risk at stake, but I think it hard to ignore that the ratings agencies are paid by those whose product they are rating. Inherent conflict of interest.
Steve