In Defense of the Rating Agencies — IV

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:

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:

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

10 Comments

  • Anonymous says:

    You make some convincing points particularly about the lack of data that would suggest losses on mortgage debt. The most telling point though is that insurers already had sufficient experience to know to avoid subprime securitizations. This suggests that there was enough knowledge out there to assess the pitfalls of subprime. This begs the question of whether without such knowledge (perhaps largely asymmetric) it would have been possible to arrive at similar conclusions given the ratings and reports. If not, then the blame should likely be placed on the ratings agencies due to negligence, incompetence, or conflict of interest.

  • David,

    I don’t think most observers have a problem with the existence of rating agencies, but with their compensation, incentives, and performance.

    A question for you: Why don’t hundreds of pension funds pool their resources and create and fund their own rating agency? Presumably, a rating agency that isn’t reliant on underwriting fees from issuers won’t have the conflict of interests that the big underwriters have had.

    • Pension investors aren’t big enough to shoulder the whole load. A better idea would be to create a private bond rater owned by all of the large bond holders — PIMCO, BlackRock, the major insurers, pensions, endowments, etc.

  • In defense of rating agencies????????? I can’t believe you would do that? They are evil, everyone knows that!

    I can’t even read your article, maybe tomorrow! You are smart, I will give you that, but this is crazy!

    What next in defense of New Century Mortgage and Countrywide?

    David, David, David

    Frank Canneto

    • Frank, I’ve said it before, I’ll say it again — yes, there are conflicts of interest. There are potential conflicts of interest in any business deal where there are more than two parties. The conflicts of interest were very well known before the crisis hit. Because they were well known, intelligent investors did their due dililence and did not get hurt. Those that did not do due diligence did get hurt. That goes for regulators as well as investors.

      And again, I have no economic interests in the rating agencies. This is what I think the truth is.

  • sg says:

    “For almost 20 years there were almost no losses on non-GSE mortgage debt. How would you rate the situation? ”

    No offense, but this is like the doctor who tells me my risk of diabetes is 10% based solely on my age. Rating agencies are supposed to look at what really causes risk, not just a track record of failures which were based on different risk factors. Not all non-GSE mortgage debt is equal. When the underlying situation changed so did the risk. They ignored the changes that increased the risk that they were supposed to evaluate.

  • sg, no offense taken. My point remains — suppose you were a quantitative rater at Moody’s, S&P, or Fitch, and you saw the bubble growing, but all of your loss statistics showed that losses occurred for borrower specific reasons, not systemic reasons. You’ve never had a model that encompasses systematic risk for housing, since that hasn’t been seen since the Great Depression.

    Building such a model would be tough. When will the losses happen, and how large will they be? What will the price path for residential housing be? You could incorporate these ideas into your model, and if it were accepted by the management team, you might be way low or way high on the eventual results — and those are being called misrating today. Hindsight bias is perfect.

    Worse, though. Whichever rating agency adopted such an approach would lose business in the short run, so management would spike such a model. It would never see the light of day.

    This is why bright investors don’t trust ratings. Only dumb investors and regulators do. But the regulators have little choice. Investors have a choice.

  • Josh Stern says:

    This piece – http://causesofthecrisis.blogspot.com/2009/09/three-myths-about-crisis-bonuses.html – argues that the faulty belief in lack of correlation across different housing markets, one of the main mistakes by the models of Moody’s et al, was also embedded in government regulations about banks’ capital ratios. This mistake directly contributed to the banking crisis.

    • Josh, good piece, though I disagree with the first point — there was irrational exuberance in the real estate markets, prompted by low initial financing costs, and momentum-following.

  • Josh Stern says:

    I brought it up because of his Part 3 related to the housing market correlations.

    But I think his attempt to draw a distinction between “obviously wrong in retrospect” and “irrational” or “stupid” is well motivated in the context of the ongoing debate about how financial institutions and markets should be regulated. In particular, regarding the question of whether regulatory action should be left up to the subjective wisdom of regulators, who would would be charged with the prevention of “bubbles” and be expected to rarely make either Type I or Type II errors on their ROC curve for bubble detection??

    It’s better, as you and others argued, to design regulations that focus on more objective constraints like debt ratios, leverage, and temporal matching of income distributions to liability schedules.

    Getting back to Moodys et al. Their individual AAA ratings can never be like the opinions of a civil engineer that a particular bridge is structurally sound for a couple of reasons. One reason is that the distributions of relevant variations are less well quantified in the security case. But the current complaint against them is that an entire class of ratings were wrong – unlike the engineer, the theory underlying their ratings of all RMBS was wrong. This points to a second reason they can’t be like the engineer – they can’t manipulate history to perform repeated experiments of their models/theories. But a third difference that we can do something about is the fact that the engineer uses theories that have survived tough peer reviews, and that is something that can’t be said for the proprietary models of the agencies.