A Couple of Thoughts on the Ratings Agencies…
While I wait to catch the train out of NYC for the weekend, I thought I’d get my post count up by putting an answer to a question in my previous post into a separate discussion of its own since it involves the ratings agencies, a subject that can (and has) taken on a life of its own separate to my last post.
North asks:
And that said I’d also ask more out of curiosity; my understanding is that currently the rating market is pretty much unregulated by the government so what/where is the hand of the free market moving to punish the rating agencies for their mis-rating fiasco?
There are regulations for the ratings agencies and the government did grant an oligopoly to the “big three” ratings agencies thirty plus years ago (I think). In addition, with the way some of the rules are set up for certain types of investors like pension funds, the incentives to get as much of a securitization pool rated AAA is huge since many institutions require that fixed income investments be rated AAA (and the ratings have to be from a Moody’s, S&P or Fitch, one of the nationally-recognized companies). The crisis did not change this so it is no surprise to see that the ratings agencies, for now, have yet to bear the full brunt of what they were responsible for.
I think that the problem with the ratings agencies was the fact that they did a poor job (mildly put) of rating the securities as opposed to the government-granted oligopoly. As it is my belief that the business model that the ratings agencies followed (i.e. being paid by the issuer as opposed to investors) was not going to change, deregulation would have meant that instead of having 3 ratings agencies fighting for market share by capitulating to the banks, we may have had several more companies. No regulation made Moody’s or S&P as aggressive with their ratings as they were. It was all about market share and profit.
Would having investors pay for a rating fix this?
How would that work? Just a surtax on Wall Street or something and just have a random house from the Big 3 get the rating contract?Report
@Jaybird, I would think so. Consider consumer FICO scores, which are indeed paid for by the lender and not the borrower. They’re set up very much for the lender’s convenience, to the point of representing certain classes of borrowers very badly.
In fact if that example is any guide, you might start to see exactly the reverse effect to the one we seem to see now. Some lenders do – to the limited extent allowed by the FCRA – game borrower’s FICO scores to make them look bad, which limits their choice of lenders and increases their rates. If the bond rating world moved to payment by the lender, you might start to see an equivalent effect – lenders would prefer more pessimistic ratings allowing them to charge more interest.
But there’s a big coordination problem. Its not efficient for individual bond purchases to each pay teh rating’s agency to evaluate the risk. Maybe traders could buy a subscription to a bond rating feed which would give them access to ratings across a range of securities, as they currently buy access to real-time news or analysis?Report
One possibility is a stamp tax on newly issued bonds, that is used to finance the ratings. Every issue gets a rating by 2 of the 3 agencies chosen by lot, no selection, funded from the stamp tax. In this way the issuer and the purchaser both pay.Report
While I think the ratings agencies screwed the pooch in this last round as much as anyone, I think it’s fair to point out that they were also playing with a deck that was heavily stacked against them from a global financial services point of view.
Specifically: While their proprietary rating analysis tools weren’t clear from those designing the vehicles, what the basic set of conditions they were using to rate products was relatively clear based on both the Basel II standards globally and the SEC in the US. That is to say: The people designing the products know what the baseline minimums and standards by regulatory bodies overseeing the ratings agencies use, and could thus design their products around those minimums with an assumed understanding that the raters themselves would only go so far as to satisfy Basel II requirements.
That’s a serious, serious problem. On the surface all of the products given AAA ratings were fine, at least by international regulatory standards, because they satisfied the bareline minimums that were set by them. Basically they knew the standards, and designed the products to meet them even if they were otherwise broken.
Transparency is usually a good thing, but it’s a bad thing when transparent rules let folks game the system.Report
Nutshell version by the by:
I don’t know if government regulation of ratings agencies would fix anything as it seems so long as a public institution is setting the standards it must invariably make them public. (Thus leaving them up for exploitation.)Report
Doesn’t this all depend on what they are being punished. If there is fraud or collusion with corporate issuers, underwriters–whatever–then by all means punish them.
But if what they did was just a lousy job at the rating function, then a fix is in order and perhaps some people deserve to be fired. But punishment? I don’t see that as helping.Report
This is my first trip here so don’t beat me up to badly.
I would like to say that this is a fantastic blog. Really intelligent and well put together discussions and essays (or “posts” is the correct term I guess).
As far as this discussion is concerned, I believe WAY to much importance and faith has been given to these rating agencies. ALL investments contain elements of risk. Caveat emptor applies to everything even AAA CDOs. I believe that greed on the part of the buyer is downplayed significantly with regard to the defaulting of the underlying loans. Who truly thinks they can receive 8-11% returns on something that has the same rating as 2% Gov’t bonds without something fishy going on. I realize that some investors may not understand fully the relationship between risk and return but there is a reason that Treasury Bonds pay such low returns; namely, they have never defaulted, almost no risk. I honestly think most buyers and sellers of these pieces of garbage knew it would never last, but they couldn’t control their own greed (Not just Goldman either, the average investor buying this crap is responsible as well).
The rating agencies, as Michael Lewis points out in his book “The Big Short”, weren’t negligent or sinister. They were just stupid. Lewis points out that in the financial world money attracts talent. Goldman pays its admin people more than the rating agency pays its CFO. I don’t know if that is true but I am sure it is close. My point is the ratings agency is not to blame at all. They were just as bewildered as most everyone else.
I also know that there were a few firms who did not even sell these products. Why? It was evident that they were not worth the paper they were printed on. These firms sacrificed huge sales, even clients, because of this but ultimately were proven to be correct. Because of this I don’t buy (pun intended) the often heard argument that no one understood these things except some french guy and Ole Lloyd. I believe an investor who correctly did his homework could have seen the inherent problem with wrapping B rated bonds together to make an A rated bond.
On an mildly unrelated note, what exactly is the purpose of these rating agencies? To protect the consumer? Then, as has been stated here, why are they payed for by someone else? It seems to me that the interest of the agency and that of the consumer are completely at odds so why trust them anyway. Do your own homework, it’s your money you are investing not theirs.Report
@Bull E, Dude. Welcome. Keep commenting!Report
@Jaybird, Thanks Jay.Report
I forgot to add that more regulation would probably only make it easier to slip one past them because of the levels of beauracracy and processes that would be heaped upon them.Report