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Fixing the Ratings Agencies
Matt Yglesias comments on the packaging of crappy loans back in the heyday of the credit bubble:
The mysterious thing isn’t that people made bad loans that they were able to package and sell off, the mysterious thing is that they found buyers for the securities.
Ultimately this looks to me to go back to the ratings agencies, an issue [Barney] Frank sort of dodged. But the ratings agencies are private for-profit companies that also enjoy a kind of government-sponsored monopoly status.
In theory their behavior should be subject to market discipline, but in practice it’s not. They screwed up badly. But while lots of companies have gone bankrupt and lots of people have lost their jobs, the ratings agencies are all still in business. And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.
No question about it: over the past decade ratings agencies were, at best, negligent, and at worst, perpetrators of outright fraud. "It could be structured by cows and we would rate it" is surely one of the all-time great quotes of the bubble era. And the fact that agencies shared their models with issuers so they'd have an easier time tweaking their products to get high ratings is prima facie evidence of corruption. Slapping a AAA rating on every cobbled-together junkpile that slithered its way out of a Wall Street structured finance group certainly helped fuel the fantastic expansion of risky investments that all came crashing down in 2008.
Still, I have to admit that over the past year ratings agencies have moved down my personal league table of bad actors. If you take a look at the list of possible causes for our recent financial meltdown here, I probably would have put the ratings agencies in the top five a year ago, while today I'm not sure I'd even put them in the top ten.
Partly this is because I've become more sympathetic to fundamental macroeconomic explanations for the bubble: easy money, current account imbalances, massive abuse of leverage, and huge increases in both debt and risk that were masked by ever more baroque credit derivatives. Partly it's because widely accepted1 risk models based on CDS spreads mostly produced the same results as the ratings agencies. Partly it's because the negligence/fraud involved in producing high ratings was pretty clearly a two-way street: buyers and sellers of structured investments were every bit as anxious to get them as the ratings agencies were to provide them.
Beyond that, I'm also a bit flummoxed about what the answer to the ratings agency problem might be. There's probably a reasonable regulatory solution for fraud and negligence, but there seems to be wide agreement that the real problem is incentives: since issuers are the ones paying for ratings, it's inevitable that agencies are going to lean into the wind to provide ratings the issuers like. I've read dozens of proposals for ratings agency reform, but the only one that really gets at this fundamental conflict-of-interest problem is to simply do away with them and turn debt rating into a government function. I'm a little skeptical of that, though, since it's not at all clear to me that a government agency could hire the kind of talent it takes to keep up with Wall Street's rocket scientists. What's more, it's not at all clear to me that anyone — Fed regulators included — would have rated SIVs much differently during the boom years than the ratings agencies did.
So....I'm not sure what the answer is. Tighter regulation would obviously be welcome, but how do we get rid of the underlying conflict-of-interest problem? How do we align agency incentives in favor of long-term accuracy? How do we encourage real competition between the agencies, rather than a race to the bottom? None of the regulatory reforms I've seen really get at this in a fundamental way. Does that mean that a government takeover is the only real answer? Or does it mean that there is no real answer and we've collectively decided to shrug our shoulders and allow this to happen all over again in a few years? Somebody should ask Barney Frank.
1Whether they should have been widely accepted is a different question. But they were.
Gummint rating agencies
A few notes about public rating agencies:
First, one of them actually exists, mirabile dictu. The insurance regulators have a Securities Valuation Office. http://www.naic.org/svo.htm They supposedly exist only to help the insurance regulators, but I can't see how their needs are different from those of investors.
Second, maybe it's true that "a government agency could [not] hire the kind of talent it takes to keep up with Wall Street's rocket scientists." But the ratings agencies suffer from the same problem. Their pay is about at the same level as the tonier bank regulators. Maybe a skosh higher, but not that different.
Also
Why not get around any issues of attracting talent by just banning certain types of structured investments altogether? If a regulator can't even begin to understand the product you just made, you don't get to sell it, period.
Maybe the CDS market has its uses but a lot of this stuff just adds no value whatsoever to anybody outside the bank that produced it. Warren Buffett has called derivatives "financial weapons of mass destruction" for a reason. Time to take the fuses away.
The Bush Administration wanted to debauch credit standards
It's hard to imagine how a government agency could have resisted government pressure to debauch mortgage standards, since the head of government, George W. Bush, announced at his October 15, 2002 White House Conference on Increasing Minority Homeownership that his goal was to add 5.5 million minority homeowners by 2010 and that the chief impediment to narrowing the racial gap in homeownership was down payment requirements.
How can we expect more hard-headed credit rating in the future if we can't even discuss what actually just happened without screams of "racism"?
Um, maybe because it's been
abundantly well established that minority home owners weren't the problem?
What about a quasi-public,
What about a quasi-public, industry-supported non-profit? "Industry," of course, means buyers and sellers.
Customers are the incentive
tagged as:- solution
If the rating agencies truly are giving out bad evaluations, then why are people trusting them? We can't regulate the acting of evaluating and giving out advice, nor is there any guarantee that people would listen to a government agency given the responsibility of performing the ratings.
These companies will stop giving bad advice when their customers leave them because of it. If the customers aren't doing so, then either they are ignorant, the evaluations are in fact good, or the bad consequences of buying these junk products isn't severe enough to make people sensitive to what ratings they're trusting.
Put pressure on the rating agencies, speak out against junk ratings while naming names, and then have investors actually suffer when things go bad. Clearly they don't feel burned enough by what's happened.
How about the buyers
pay the ratings agencies, not the sellers? Didn't I read about one rather large bank or fund that didn't get into trouble with this stuff because it insists on hiring the ratings agencies itself, demanded saner evaluations and got them?
Ratings Agencies as Buyer Agents
First - I don't buy your alternatives, Kevin - none of those things would have happened had ratings agencies fulfilled their central mission, because no one would have bought financial products with CCC ratings. Problem solved, no?
It strikes me that of everyone involved in the whole debacle, only one group clearly signed their names to things they knew not to be true. Those guys at S&P and Moody's ought to be liable.
Second - gyrfalcon is right on. Frankly, it seems obvious - maybe I'm missing something? I want to buy a bond, I pay for a rating or I take my chances. Maybe I join a co-op that maintains a relationship with a ratings agency to make the process more efficient. Clears the incentives right up - the ratings agency exaggerates the value of a bond, I move to a different agency.
Make'em Pay
Changing the system to have the buyer pay for the rating instead of the seller will not automatically solve the problem. Many buyers are just as interested in an inflated price as the seller because the buyer's fees are determined by the size of their purchase.
The system needs to have monetary, and possibly licensing, penalties for the rating agencies that do poor work. As it stands now, the only penalty is to their reputation. And with too many high rollers, a bad reputation is a recommendation.
Perverse Incentives
OtterBil said:
> Many buyers are just as interested in an inflated price as the seller because the
> buyer's fees are determined by the size of their purchase.
That seems like a surmountable problem - an agency whose fees were determined transactionally wouldn't have that incentive. This could be enforced by regulation, but perhaps in the brave, new world of investor-focused ratings agencies, an upstart, young company might see an opportunity to differentiate itself by offering an innovative, new fee structure that worked better for its customers.
Sojourner said above: If
Sojourner said above:
There is another explanation -- which I think is the correct one: The "people" who were trusting the evaluations and bought the junk were acting in their own personal self-interest, not in the interest of their companies and their shareholders, and even less, of course, in the public interest. In general, this worked pretty well. They used the ratings as excuses to do things that bankrupted their companies and caused the meltdown -- but made themselves fabulously wealthy, and they get to keep every penny. Given the chance (and it seems they are being given it) they would do it again. What do they have to lose?
What DJ said. Okay the
What DJ said. Okay the rating agencies gave bad ratings. Someone still had to trust them. If you trust someone's advice as what to flatscreen to buy, and it turns out badly, it's still you the buyer who is considered responsible. What kind of financial system is it where people spend millions and millions on instruments they *do not understand*, simply on the advice of others, when it is clear that the rule (because the rates paid on these AAA are higher than other AAA) "no free lunch" is being violated.
AAA ratings had major effects
Kevin, I think you underestimate the effect of the ratings agencies. It wasn't just that AAA ratings attracted more investors. Many investors like pension funds, endowments, mutual funds, insurance companies, municipalities, etc are forbidden by charter to invest in bonds that have lower ratings. So a major motivation for creating tranches and juicing the ratings was to open up markets that were otherwise closed to junk.
In addition, the reserve ratio requirements for banks are tied to the quality of their capital reserves. So holding AAA rated investments allowed banks to have higher leverage. The banks were gaming the capital reserve requirements to engage in higher risk.
A Better Idea
tagged as:- solution
We can find the answer in the field of scientific research: the double blind study. The idea is that the ratings agency doesn't know who is packaging the securities, and the securitizers don't know which ratings agency is providing the rating. Obviously this requires the government to act as an intermediary, and it requires standardized fees. Furthermore, it would require strict criminal penalties for subverting the blinding process. As with any worthwhile endeavor, it wouldn't be easy. But it would work.
I don't think the government
I don't think the government should get into the "micro" business of rating individual instruments. But it can, and should, monitor and analyze the markets and evaluate overall risk. In fact, the Fed (which is "almost" a government entity) is already supposed to be doing that. At the Fed's website, we read:
The Fed regularly inspects major banks and evaluates their risk positions. Risk managers at big banks have to talk to Fed examiners. At a minimum, the Fed should be able to come up with an overall assessment of systemic risk -- that is one of its self-acknowledged functions. Leave individual ratings to the rating agencies, but monitor and evaluate the job they are doing -- then advise congress.
Would it work to force the
Would it work to force the ratings agencies into some kind of third-party-controlled (government?) pool where the third-party matches up a product's buyers or sellers with a rating agency?
This is the same conflict of
tagged as:- solution
This is the same conflict of interest that occurred with house appraisals. For real estate, it's been fixed by having the buyer of the house pay for the appraisal, instead of the seller. For ratings agencies, aligning the interests of the rating agencies with buyers (instead of sellers) would avoid the conflict on interest.
This may not help much. When
This may not help much. When you have decided to buy a house you don't really care too much about what the appraiser say as long as he gives a number that makes the mortgage provider happy.
Same way in finance. As a buyer you have typically already decided that you know best and you just want the rating to either confirm that or be high enough such that you are allowed to invest in it or (if you are a bank) can minimize the regulatory capital charge.
A number of other posters have mentioned the same thing, buyers are often interested in the high rating too!
Just force the ratings
tagged as:- solution
Just force the ratings agencies to buy and hold to maturity some of everything they rate. Also legislate that their fees can't be more than a fraction of the amount they have to hold. This way the ratings agencies have to assess assets correctly so as not to become insolvent. Also, they will need a capital base and need to select what is worth rating rather than rating everything will nilly.
How about reverse libel?
Ratings agencies say they are media and protected by the first amendment. But the first amendment does not protect all speech. Speech intended to damage a reputation is not protected if it is fabricated for that purpose. But fraudulent speech intended to promote a reputation, in this case, can be shown to be a fabrication and to have caused harm.
Congress doesn't need to act to create new regulation. Couldn't it, rather, give standing to those individuals and groups who are harmed by the corrupt dealings of ratings agencies?
fundamental macroeconomic explanations
Get rid of the shadow banking sector. Bring back Glass-Steagall.
On the issue of the ratings agencies, Congress should remove their monopoly status and the requirement that they be used. It's insane to think you'll get a true rating when the company you're interested in is paying for its rating. Talk about a gigantic conflict of interests.
These measures will address the fundamental macroeconomic explanations. That'll never happen, but it would solve the problem.
I'm not anonymous. I'm zak822.
From the trenches
If you're looking for a government role in the ratings industry, how about meta-rating? If all the gov had to do was track and publicize the long-term accuracy of a ratings agency, they could provide a check on the agencies' methodological silliness, and be pretty transparent in their machinations. And it wouldn't require much of a savant to run a "winnings percentage" on the overall performance, so the salaries could be modest. Light-handed regulation, unbiased information.
I'd like to think that reputation alone would drive the actions of these firms, much like it was supposed to have for the accounting firms (i.e. Arthur Andersen). But in this case they didn't even get hammered after the fact, which I don't understand in the slightest. ...Unless their true customers are the issuers themselves, which seems pretty likely.
Wall Street rocket scientists: not actual rocket scientists
See, actual rocket scientists benefit society (we can disagree over how much, obviously). Wall Street "rocket scientists", on the other hand, harm society. Their only purpose is to enrich their employers, and as we've now learned, much of what they produced was, quite simply, fraud, dressed up in fancy, near-incomprehensible mathematical formulas. If the government agency can't understand it, then guess what? It won't rate it! What purpose does it serve to take an incomprehensible investment formula and reduce it to a single letter grade? None; unless, of course, you plan on marketing that investment to a bunch of chumps. After all, it's not like the existing ratings agencies understand this stuff either. It's just that their default position is to rate it (AAA, ideally), whereas the default position of the government agency would be to not rate it. And if these motivates a bunch of Wall Street rocket scientists to devote their considerable intellect to some other field, even better!
Ratings Agencies
Since it's pretty obvious that the customers of the ratings agencies were complicit in the fraudulent AAA ratings, indeed, THAT is what they were explicitly "buying", then once again it just seems to me that the only way to effectively "align incentives" is to make the financial agencies and their employees responsible for their own losses. If they had to play by the same rules as everyone else (ie, not "too big to fail"), they would not be willing to take the risk on a (incorrectly) highly rated security, and would therefore immediately begin insisting on accurate ratings...
mikey
Drum: "None of the
Drum: "None of the regulatory reforms I've seen really get at this in a fundamental way. Does that mean that a government takeover is the only real answer? Or does it mean that there is no real answer and we've collectively decided to shrug our shoulders and allow this to happen all over again in a few years?"
It's not surprising that you would find that the only alternatives are "government takeover" or "no answer." You simply don't understand that this is about human nature -- not macroeconomics. Some activities -- driven by nothing but pure greed and self interest -- cannot be "regulated" by a political apparatus dominated by moneyed interests. They need to be PROHIBITED -- with severe penalties.
Allowing our banking system to engage in ANY of these risky activities and hoping to avoid another catastrophe through "regulation" is madness.
The alternative isn't "government takeover;" it is simply separating traditional banking functions from investment banking functions. Letting criminals like Goldman who caused the problem have access to bank deposits and hoping to "regulate" the outcome is pure insanity.