Tales from the Dark Side
Noah Millman has a fascinating post about his initial belief in the promise of synthetic CDOs and his eventual disillusionment. Ultimately, it all comes down to what the ratings agencies were willing to let people get away with:
How did a market that, I thought, had really helped capitalism work in 2002 become the great destroyer of capitalism of the last two years? There were a lot of contributors to the catastrophe, but one indispensable one is that the ratings agencies monetized their sterling reputations in an extraordinary fashion, and nobody in regulatory apparatus of government saw that this was happening, and what it might portend. The success of 2002 depended on market confidence in the ratings agency process: that’s what made investors willing to buy the notes issued by structured finance vehicles that issued the credit protection that made it possible for banks to hedge. Without that confidence, the market would never have developed. And by 2006, the agencies understood just how much that confidence was worth. [...]
Now, of course, the agencies have radically reversed course. They have completely changed their models, of course. But they’ve also begun to “follow the market”, incorporating credit derivatives swap and equity market pricing into their ratings for companies. If in 2006 the market had, to an alarming degree, delegated its risk-management to the ratings agencies, now the ratings agencies have delegated a great deal of their ratings process to the market. And so the market has lost any reason for confidence in the agencies in both directions: they cannot be trusted when the market is strong to assess the downside risks the market is ignoring, and they cannot be trusted when the market is weak to assess a company’s financial condition independently of the market panic.
I’m not really sure what we’re supposed to do about this. I’m inclined to say that if ratings agencies are going to have such an important public function we ought to have that function performed by a public agency. In practice, as soon as people went back to not wanting to pay attention to financial services regulations, I think you’d have a big regulatory capture problem. But beyond the fact that the private ratings agencies performed poorly, the fact of their poor performance doesn’t seem to opened the market to competition or new entrants or whatever it is that leaving this kind of thing in private hands is supposed to accomplish.
27 Responses to “Tales from the Dark Side”
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December 25th, 2008 at 10:21 am
Competition between Wall Street firms made it almost impossible for cautious fund managers. For example, the “super senior tranche” of a CDO might have a top credit rating and pay slightly more than other top rated instruments. Suppose you run a conservative bond fund that promises to invest only in top rated bonds. If you refuse to buy the higher yield CDO instruments, your fund will have a slightly lower return than other funds that to. Investors choosing between funds by return (as most investors do) will choose your competition and you will go out of business.
December 25th, 2008 at 10:41 am
The answer is easy. If it isn’t regularly traded on an exchange it has a zero value on the balance sheet. When it is sold the gain or loss is recognized. If the Fed and SEC had done this the problem never would have happened. You had people assigning notional value to assets that due to permitted leverage allowed more of the same.
December 25th, 2008 at 10:57 am
1) The first place to start is to destroy the careers of the analysts and managers at the Ratings Agencies who put AAA on dreck. Name names.
2) But the REAL problem is not Regulation of Wall Street — it is Regulation of Congress and the WHite House. Billionaire Warren Buffet owns 20 percent of Moodys — which I’m pretty sure is a controlling interest. Given that Barack Obama thinks ole Warren’s shit don’t stink, I wouldn’t expect any federal criminial investigations into the ratings agencies any time soon.
3) So the larger problem is that we need to scrap that pile of stupid shits on the Supreme Court who defend a system of bribery and malign corruption that is destroying this country.
4) We need to scrap the Supreme Court — it’s not really defined in the Constitution anyway and it’s review authority was merely an illegal power grab by John Marshall. We should amend the Constitution to give the Supreme Court’s function to the state legislatures to manage how they see fit.
5) We similarly need to make our News Media and Campaign Processes into functions carried out by an independent agency whose management is appointed by –and serves at the pleasure of — the state legislatures. No military unit or corporation would long survive if its leaders had to depend up an information system as deceitful and corrupt as our News Media and political campaigns.
6) The most fundamental idea in the Declaration of Independence and US Constitution is that the People are sovereign. But our present day government makes a lie out of that idea every day. It’s time to scrap this kleptocracy and replace it with a government is of, by and for the People.
December 25th, 2008 at 12:09 pm
I haven’t finished reading the post in question, Matthew, but I gotta say, it sounds like every other kind of insider explanation I’ve heard: a bunch of gambits involving making money out of nothing a second (or third, or fourth) time and being shocked when it exploded in their faces. Oopsie.
The actual interesting thing is not how group XYZ failed, it’s how these guys fooled themselves into believing this shit. And they still quite can’t shake it loose.
max
['It's a fuckin' cosmic accident!']
December 25th, 2008 at 12:36 pm
One thing that we can do is make it illegal for brokerage houses and ratings agencies to be as intermingled as they’ve been. I’m looking at you, Buffet.
December 25th, 2008 at 12:39 pm
What max and RMF said.
Millman’s piece is just one more bulls**t “but nobody could have predicted!” story to toss on the stack.
December 25th, 2008 at 12:43 pm
Yes, ratings agencies perform an important function. So do investment houses and banks. Also, consumers. I suppose Matt will want to nationalize all of these.
This isn’t thinking or writing. It’s like scratching an itch.
December 25th, 2008 at 12:46 pm
Yes but you’re neglecting to mention the extremely relevant fact that the credit rating agencies were explicitly approved by the SEC (look up a list of NRSROs – “Nationally Recognized Statistical Rating Organizations”). It doesn’t seem plausible to me to say that the fact that certain ratings agencies had the explicit backing of regulators had little impact on the confidence that was placed in them. And once you accept that, what case do you have for thinking that a state-run rating agency would do much better? After all, it’s the ones under the SEC’s purview who screwed up so badly – and if the government can’t even regulate them properly, what hope does it have of running them?
December 25th, 2008 at 3:28 pm
See here for full details, but suffice to say that the SEC was plenty aware of the problem. Chris Cox just didn’t want to regulate.
December 25th, 2008 at 4:06 pm
One of the things we should be trying to do, is to dramatically increase the time horizon that decisionmakers use to evaluate success. Looking at this from the point of view of a manager at one of the ratings agencies, “monetizing their reputation” was probably a rational way for him to reap nearterm rewards on his stock options. With such a system of rewards (including the possibility that the manager in question might not be in a position in say five years to benefit from the firms longterm profitability), the temptation to make a nearterm killing is just too strong.
December 25th, 2008 at 4:45 pm
What Dan W. says. There’s no entrants to the rating agency business because you need SEC approval to become a recognized agency. Which is no doubt a long, laborious and expensive process.
To solve the problem you need to change the incentives, which means you need to take the direct relationship between agency revenue and ratings away. Have public firms pay into a ratings pool which then assigns the rating, randomly, to one of several recognized firms. The agencies would then have as their ‘client’ the the oversight board running the pool and not the companies themselves. Presumably the incentive would be for accurate instead of inflated ratings.
Fully fund the SEC enforcement division so it can keep track of agency performance.
Or turn the whole thing over to the SEC and let them do the ratings.
December 26th, 2008 at 1:07 am
If the company being rated is also the one paying the rating agancy, why should anyone be surprised that they got the ratings they wanted? I don’t see any market failure here that would open up the field to competition. It never made any sense for the company being rated to also be the customer. The conflict of interest is flagrantly obvious. All those people relying on the rating agencies weren’t paying a penny. They got the rating quality they were paying for
December 26th, 2008 at 3:40 am
Good Lord. Can you even begin to imagine how terrible a government-run stock ratings agency would be? The opportunity for lobbyist double-dealing and corruption here is just staggering. The only conceivable way something like this could work is if it was entirely insulated from any political process, like the Supreme Court, which for a project of this magnitude is obviously completely impossible. I know this is saying a lot, but this has to be one of Matt’s worst knee-jerk calls for nationalization ever.
December 26th, 2008 at 5:19 am
The failure of Moody’s et al to rate these instruments correctly helps to undermine the theoretical case for ‘private sector regulation’. Chicago school free marketeers tell us that we don’t need government to regulate industries. If people really want to know who the good and bad actors are, then private regulators will emerge to separate the sheep from the goats for a price. The firms that do the best job will win out in the long run, and we’ll be left w/ reliable rating entities in any field where people care about quality.
If this sort of private regulation has any real world exam-ples, it would seem to be Moody’s, S&P and Fitch. But they’ve failed miserably. I like Millman’s phrase: they ‘monetized’ their reputations. Once private regulators secure their reputations, they’ll be under intense financial pressure to “over-rate” in exchange for payoffs of some sort. After all, in good times, few of the over-rated securities will default, so the risk to the agencies’ reputation is small. That over-rating will go undiscovered until the first broad recession. Which is where we are now.
Also like Millman’s implicit reference to the buck-passing feedback loop that has developed. Rating agencies over-rate, so the market buys. Then the rating agency models include market price as an independent variable, and agencies conclude: our ratings are correct. When the securities are revealed to be frauds, tha market participants can blame the rating agencies, and the rating agencies can blame the market. Since everyone is equally at fault, there is no one to blame, so everyone is entitled to a bail out.
(But look! Over there! The auto execs took private jets to Washington!)
Another $350 billion, please.
December 26th, 2008 at 7:56 am
Our wingnut posters have taken advantage of our host’s omission and their own ignorance, pouncing on his tentative proposal for a public ratings agency as some kind of unworkable socialism.
It may be socialism, but it is not unworkable. A public rating agency has long existed in the insurance industry: the Securities Valuation Office. It even has a website. http://www.naic.org/svo.htm
Of course, some wingnut will post downthread on how this isn’t really a public ratings agency, or (based on no data) how it really doesn’t work, or that it is gay, or something.
December 26th, 2008 at 12:18 pm
I love that people can, with a straight face, say things along the lines of Can you even begin to imagine how terrible a government-run stock ratings agency would be? Horrors! Why, a government-run stock ratings agency might fail so catastrophically as to bring about the worst financial crisis since the Great Depression!
December 26th, 2008 at 7:06 pm
You guys can’t be serious. Clearly the private ratings agencies (along with many other people) screwed up in the worst way possible…but I honestly don’t understand why you think nationalizing them would be some kind of silver bullet that would suddenly make them all competent and efficient. We’re talking about a government agency that would be responsible for rating the stock of every publicly-traded corporation in the country, and therefore a government agency that every corporation in the country would be trying to influence to their advantage.
How can you guys read all of Matt’s (entirely justified) posts about how badly the SEC and other govt regulatory agencies have screwed up during this crisis, and then turn right around and call for a publicly-run ratings agency that would have all the same problems, only a million times worse?
December 27th, 2008 at 1:19 pm
The SEC regulates which companies can be NRSRO’s very strictly. You can’t just rely upon any old johnny come lately credit rating agency
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