I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies. Those who want historical context can read my earlier three pieces:
- In Defense of the Ratings Agencies
- In Defense of the Rating Agencies — II
- In Defense of the Rating Agencies — III
And let me repeat my five realities:
- There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
- Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves. The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies. The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
- New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
- Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
- Ratings can be short-term, or long-term, but not both. The worst of all worlds is when the ratings agencies shift time horizons.
First, please understand that institutions own most of the bonds out there. Second, the big institutions do their own independent due diligence on the bonds that they buy. We had a saying in a firm that I managed bonds in, “Read the writeup, but ignore the rating.” The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line. They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.
So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles. They know that ratings are just opinions, except to the extent that they affect investment policies (“We can’t invest in junk bonds.”) or capital levels for regulated clients.
On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument). Now, sophisticated investors knew that AAA did not always mean AAA. How did they know this? Because the various AAA bonds traded at decidedly different interest rates. The more dodgy the collateral, the higher the yield, even if it had a AAA rating. My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit. Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same. Early in the 2000s, sophisticated investors got burned, and learned. That is why few insurers have gotten burned badly in the current crisis. Few insurers bought any subprime residential securitizations after 2004. But, unsophisticated investors and regulators trust the ratings and buy.
Recently, the rating agencies have lost some preliminary arguments in a court case where a defense they made is that ratings are free speech has been shot down. I must admit, I never would have made such an argument, because it is dumb (See Falkenstein’s logic on the matter). People and corporations cannot say what they want, and say that they are immune from prosecution because of free speech. Fraud, and implied fraud from speech is prosecutable.
But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument. A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits. Instead, they do some qualitative comparisons to similar but established financial instruments, and give a rating.
Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden. Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique. As it is, when liquidity declines and leverage follows, all manner of errors gets revealed. Gaussian copula? Using default rates for loans on balance sheet for those that are sold to third parties? Ugh.
But think of something even more pervasive. For almost 20 years there were almost no losses on non-GSE mortgage debt. How would you rate the situation? Before the losses became obvious the ratings were high. Historical statistics vetted that out. No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.
When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed. In this case both raters and investors have had their heads handed to them. And so it is no surprise that the rating agencies have no lack of detractors:
- Moody’s, S&P May Face More Disclosure, Liability in SEC Rules
- SEC Looks to Prohibit Flash Trade, Curb Raters
- Debt Raters Have No Place in Brave New World: Alice Schroeder
- Anschutz Sues Bond Raters, Banks Over Auction Rate Securities (poor guy. Did he read the extensive risk factors in the prospectuses? The risks were revealed.)
- Cramer: Clamp Down on Credit-Rating Agencies
I may attend a meeting this Thursday on the rating agencies and the insurance industry, if my schedule permits. If I get a chance to speak, I hope I can make my opinion clear in a short amount of time.
As for solutions, I would say the following are useful:
- Competition (yes, more rating agencies)
- Compensate with residuals and bonuses (give the raters some skin in the game)
- Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
- Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
In economics, where there are more than two players, easy solutions are tough. I only ask that solutions to the rating agency difficulties be reasonably certain that they do not create larger problems. Ratings have their benefits as well as problems.
No economic interest