Rating agencies grew up rating corporate credit risk.? The nice thing about corporate credit risk is the failures happen at least every seven years.? There was a sideline on municipal credit risk, but since munis rarely defaulted, it was not very relevant.
Guess what?? Moody’s, S&P, and Fitch are very good at predicting corporate default.? Some new players are better still, but their ratings change more rapidly, which has pluses and minuses.? They are faster to identify failing entities, but they also have more “false positives” where they signal failure, and it does not happen.
GICs
Go back to the late ’80s.? The rating agencies were trying to evaluate the newly popular 401(k) investment Guaranteed Investment Contracts [GICs].? Guess what?? No GICs had ever failed.? What’s the right rating for all the companies offering them?? If the history is so positive shouldn’t everyone be AAA?
Though some of the larger companies had corporate debt that traded, GICs were not obligations of the holding company, but of the insurance subsidiary.? Not only that, unlike bonds, GICs (in most states) were policyholder obligations, not debt per se.? GICs were often super-senior obligations of subsidiaries of the company.
So, how to rate them?? Since there were few historical losses, and the rating agencies lacked a forward-looking view of what might happen, they rated most GICs AAA or AA.
After a few GIC-issuing companies went into insolvency, those ratings changed rapidly over the next seven years, leading to many exits by marginal players who did not default, a few defaults (with almost no losses), and a much smaller GIC industry dominated by synthetic GICs that relied upon insurance company derivatives.
Securitization
Because the regulators required ratings, the rating agencies were willingly drawn in to rating structured products.? With the GSEs it was easy — there is no credit risk, so they are AAA.? With the non-guaranteed whole loans, it was tougher — no GSE guarantee.? How to rate?? This was a new product, a new risk, and so the rating agencies looked at resident mortgage default rates in the past.
Very much like the error of health insurers in the ’60s, where they tried to calculate utilization of healthcare services from the non-insured and apply that to the insured, mortgages retained by originators defaulted less frequently than those that were sold to third parties.
The rating agencies could get the math right on securitization, but could not get the parameters right.? All of their loss data came from an era where lenders held onto their loans.? Selling loans, and having servicing as a separable function was totally unknown to the past.
Much as those who implemented securitization were relatively farsighted, they did not take into account the agency problems involved in “selling to securitize.”
The rating agencies did the best that they could in a competitive environment, with little relevant loss data to guide them.
I suspect that they will do better before the next cycle of failures transpires.
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In short, my point is this: the rating agencies, blundered with ratings on securitization.? They will be better in the future, because they finally have real data to work with.? They are trying to be more forward looking on sovereign issuers, with some degree of pushback.? My view is that those that object more should be downgraded further, within reason.? I differ from the rating agencies, because I am more skeptical, and imaginative.
“Figures don’t lie, but liars will figure.” Issuers are not objective with respect to their own debts.? Rating agencies should ignore the issuers, and work off? of publicly available data, lest they be subverted by the issuers, as has happened.
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I don’t fault the rating agencies much with respect to sovereign ratings.? They seem mostly rational to me, though? there is little real default data to guide them.
That’s the crux of the issue here — they don’t have many sovereign fiat currency defaults to guide them.? Does that mean the odds are low?? By no means.? A larger model, including political motivations, and using game theory would indicate that there are possibilities where no coalition governs that debts will be paid.
I hate the simplistic models of the Keynesians and their bastard progeny.? One has to think more broadly, and consider the wide range of what might happen, because (surprise!) people/institutions aren’t always rational as economists view them.
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I leave you with this: imagine that you run a rating agency, and your clients ask you to rate debts that you don’t have a good model to use.? You have competitors, and they are seeking advantage as well.? Add into the mix that the issuers can choose who they want.? How do you react to a new class of credit?? The question is a hard one.
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And thus, to those who trash the rating agencies because of bad past decisions, I say, “Could you have done better, you have the benefit of hindsight?”
The rating agencies are flawed but are mostly honest dealers who used bad models on structured credit, because no one knew better.? They took the risk and put forth some bad ratings.
For this reason I say to the fools who argue against the S&P downgrade of the US, “How do you know?”? For once a rating agency is trying to be proactive, and they get a lot of abuse.? Watch the trading in the market, it will tell you a lot more than the downgrade.
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And thus, to those who trash the rating agencies because of bad past decisions, I say, ?Could you have done better, you have the benefit of hindsight??
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Well, I did. And many others did as well. And hindsight has, more fully, confirmed that the critical elements in economic functioning were… in fact, malfunctioning. And that word (malfunctioning), w/in the context you are addressing, would require a litany of descriptions detailing so many moving parts that, both in hindsight and current real time, they are… devastating.
The ratings agencies did nothing, within the context of their purported functioning, during buildup to (pick your term, I’ll call it the) housing crisis.
They rated what their mortgage bond issuers wanted. Period.
I have told you in the past, David, that… as I see it, your context is too small. I think current “things” bare that out.
If you read (have read) various comments from Treasury/Fed officials during recent DOW dive, it seems to me illuminating of this very fact. Bernacke’s models, they admit, don’t seem to be working. Other comments from these guys say, well… there are “new things happening” (bloomberg) which they are trying to comprehend. And this, nearly 5 years after the grounding was set for collapse, and no meaningful corrective measures were taken.
People are asleep. They don’t see what’s in front of their eyes. They believe what corrupted influences tell them, further eroding their own integrity.
They are following a bouncing ball, while oblivious to the environment in which the ball bounces.
We are in trouble, because, (not just) US public as a whole has no consciousness wrt what it is our challenges are… even for survival… much less bringing forth our human capabilities to meet them.
We are operating on assumptions decades old, with little recognition that our living environment no longer fits those circumstances.
Food (ag) shortages are emerging, world wide. They are, most fundamentally, driven by climate change (warming). Our technology is near maxed out on food production, and currently incapable of even coming close to adjusting for this hugely altered environment.
Not even close.
The $USD, currently, represents no longer relevant concepts wrt dynamic economic activity to meet human needs. The “assets” remaining, are substantial, but only wrt value with in contexts of no longer relevant assumptions. And… those assets have been plundered hugely in (especially) most recent decade, with net value decreased rather then added.
S&P’s downgrade of US debt is the tip of the tail on a sick dog. It’s almost comical, AFAIC. “Investors” react to this kind’a stuff, but largely remain oblivious to the meaningful context, that being the whole world we live in and the greatly diminished capabilities of it’s human inhabitants.
As I’ve said before, we (US especially) aren’t even to the starting line yet, wrt to accessing, comprehending, and putting forth human activity in order to address a future which, currently, is identified and defined by powers that be (US gov & it’s decision makers) as moving this or that into or out of balance sheets so as to produce another estimate of solvency.
But as before, this estimate ignores the totality… or as I’ve said, “critical mass” of conditions, which, given their accumulated severity of self evident consequences is looming closer… these “estimates”/”models” etc. are… really, just a bunch more nonsense.
It’ (rating agency “debate”) is irrelevant to anything, meaningfully necessary, in order to bring human activity to bare for that which to be done. Given current momentum of things, the totality of enviromental (and I don’t mean in “green sense”, I mean all conditions/things affecting where we live) are set to so overwhelm basic assumptions of life in ways that, when that begins (I say it already has), it is going to leave most folks w/2 basic, very very non-utilitarian conditions:
a) their money will not do what they have become accustomed to expecting of it.
b) because of enduring slumber, consoled and nurtured by reliance on $$ to exclusion of their own commons sense, human problem solving abilities currently dormant, the required human conditions for resolve and purposefulness to correct will not be available for them.
As I’ve told you before, proper economic functioning, w/reliable currency, requires that currency to reflect the activities w/in totality of economic activity. When that equation is reversed… when the $$ dictate the functioning, it becomes similar to someone driving their car by steering with the rear view mirror.
It’s really, quite plain to see. Just way… way too few people *seeing*, w/commensurate huge lacking of critical mass of such people to move things.
…
Ok, I know you hate this stuff from me. But… on occasion, for a while now, just seems necessary to point out exactly what I’ve pointed out before. We’re worse off then 2 years ago, for exact same reasons I say here having futher eroded “things”, yet… almost all are sort’a standing around, waiting… “thinking” it will all be ok when “things” just kind of, you know, turn around… ’cause that always happens.
Right?
Have a good day, David.
David,
There are indeed many commentators capitalizing on rating agencies mistakes without casting light on their success in other chapters of finance. And the argument you are making is compelling.
However, I find many resemblances between portfolio assumptions made by credit raters from the ’85-’91 period to what happened in the subprime buildup. I should mention I make this analogy without having lived through Milken’s junk bond cycle, but having read a few books written in the aforementioned period. Weren’t they supposed to have learnt one or two lessons from those times?
Please note I am aware of some possible flawed assumptions in my humble conclusion and I would like to know your point of view, as a market participant then and now.
Respectfully,
Alexandru
However, I find many resemblances between portfolio assumptions made by credit raters from the ?85-?91 period to what happened in the subprime buildup. I should mention I make this analogy without having lived through Milken?s junk bond cycle, but having read a few books written in the aforementioned period. Weren?t they supposed to have learnt one or two lessons from those times?