I have a question about John Tamny’s article about the role of the ratings agencies in the financial crisis of 2008 at RealClearMarkets:
Which brings us to 2008, or 2007-2008 if readers prefer. It really doesn’t matter. Going back to that timeframe it was said by some that faulty ratings of mortgage debt by the agencies set the stage for 2008 by tricking financial institutions into buying bad debt. No, that’s not realistic either. Nor was it.
It would have been nice if he had actually cited some quotes to verify that since I don’t recall anybody saying that. What is incontrovertibly true is that the ratings agencies didn’t prevent the financial crisis, a somewhat different proposition than claiming that they “set the stage” or caused the financial crisis in any way.
I see the ratings agencies as rent-seekers that wouldn’t exist without their federal mandates which should be abolished since they aren’t serving their putative purpose. Caveat emptor remains the standard and there’s little that can be done about that.
A blanket assessment of ratings agencies as pure rent seekers is just as wrong and overwrought as assessing them virtuous and sparkling analysts.
The slicing and dicing of cash flows and order of repayment preference is always missed in these arguments. AAA rated tranches were just that, by quality and payment preference. Those investors seeking yield in lower quality or subordinated tranches either a) knew the risks or, b) were incompetent to the point of breach of fiduciary duty.
A ratings agency may, in fact probably, has lesser standing than generally acknowledged, but an investor can’t outsource the investment decision. That’s why you get paid.
The ratings agencies’ conflict of interest is inescapable.
All I’m asking is that an agency rating no longer be mandatory. Alternatively, the criteria for ratings agencies could be expanded.
I don’t believe their present business model can be sustained on that basis.
I’m working from memory here, but as I recall the problem with the ratings agencies in 2007-2008 was that they were giving AAA ratings to stuff that should have been junk.
The problem is, can you trust the rating?
“The ratings agencies’ conflict of interest is inescapable.â€
Conflicts are everywhere. Everyone knows that.
“All I’m asking is that an agency rating no longer be mandatory.â€
It’s a crude tool for sure. They just do the analytical grunt work. Any damned fool can do analytics. At some point you have to make an investment judgment. That’s hard.
“but as I recall the problem with the ratings agencies in 2007-2008 was that they were giving AAA ratings to stuff that should have been junk.â€
No. That’s the pop and very superficial storytelling. Go read, and think about, what I wrote. The very essence of securitization is to take the cash flows of some black box (in this case mortgages) and assign them through security contracts having various risks, preference in liquidation, current pay provisions, default remedies etc etc, AAA rated tranches were AAA, based upon the criteria I just cited. Junk tranches were junk, based on the same, but inferior, characteristics. Everyone knew it. The agencies and the investors. They aren’t fools. Only those buying the simplistic version of events are fools. See Steve’s usual rants.
The real issue was more fundamental. When the housing bubble burst the interbank and commercial paper lending markets froze because you didn’t know what your counterparty risk was. What does their balance sheet look like? AAA, or junky? The ratings agency didn’t make that decision, or what an acceptable mortgage risk was; investors did, combined with serious government arm twisting, and Fannie/Freddie as a dumping ground, for social policy reasons.
Being huge advocates for EZ mortgages, Mr Dodd and Mr Frank have mucho blood on their hands in this, and were in dire need of something exculpatory. And that’s why we have Dodd Frank “reform.†Snicker.
As they say. You can’t make this shit up.
In all of the rest of the world you just follow the money trail to see who made all of the money to see who bear’s the lion’s share of blame when there is a financial catastrophe. But in Drew’s world the people in finance have no agency. They were just forced to make billions of dollars. Nasty Dodd and Frank, who let’s remember were minority members of Congress, forced the Republicans (who also had no agency or responsibility) to pass rules and laws that forced the finance sector to become rich. Nevermind the fact that the banking sector has tried the same or similar tricks in the past well before Dodd and Frank controlled Congress, as minority members.
Drew could certainly be correct that many investors knew that those AAA ratings were actually meaningless. I have often waffled back and forth on whether the people running the finance sector were idiots or crooks. In some ways it is more reassuring to think they were just crooks. What seems pretty clear is that downstream the knowledgeable investors at the big banks were selling their products to people running retirement funds, just an example, who really didnt understand the products that well and they thought that AAA meant something. The salespeople kind of forgot to explain that AAA meant some portion of what they were buying was really AAA, but that a lot of the loans were given out without confirming that the lenders even had any income so they had no idea if they could be paid back.
I would strongly agree with this.
“lending markets froze because you didn’t know what your counterparty risk was. What does their balance sheet look like? AAA, or junky?”
With the ratings agencies handing out AAA ratings to everyone, and let’s not forget that they got paid to hand out those AAA ratings so they had incentives to do that, no one knew what anyone else was holding. AAA was meaningless. Either do away with the ratings agencies or regulate them into doing their job correctly.
Steve