THE RATING AGENCIES….In the New York Times magazine today, Roger Lowenstein takes a look at the role of rating agencies in our current credit crisis. Were they at fault because they got in bed with their customers and overrated complex new mortgage-backed securities? Or were they innocent bystanders in a world gone mad?
Proposition A gets an airing early on. Lowenstein explains that after the sudden collapse of Penn Central in 1970, new rules were put in place that effectively barred large classes of investors from buying anything other than investment grade bonds. And it was the rating agencies that decided which bonds were investment grade and which ones weren’t:
Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position.
….The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them….But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A [big deal] can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”
And it seems to have helped the banks get better ratings. [Joseph] Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.’s defaulted eight times as often. One interpretation of the data is that Moody’s was far less discerning when the client was a Wall Street securitizer.
….Nothing sent the agencies into high gear as much as the development of structured finance….Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails….The challenge to investment banks is to design securities that just meet the rating agencies’ tests….”Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”
Even a small tweak in a rating can make a big difference, and both the rating agencies and the banks issuring the bonds have an incentive to tweak things in the bank’s favor: the bank because it makes their offerings more profitable, the agency because it makes their client happy. Whether or not the agencies are “keen to the dangers” of this, it’s naive to think that it doesn’t happen. It’s a lot like the “Chinese wall” that was supposed to separate the supposedly independent research analysts from the investment bankers at financial services firms during the dotcom boom. Guess what? It turned out the wall was made of rice paper.
But then there’s Proposition B. It suggests that the rating agencies used historical models to analyze mortgage-backed securities, and in the brave new world of subprime hegemony and structured finance, their old models broke down:
Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined. This was rather intuitive; Moody’s simply hadn’t reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time. Translation: even people with good credit scores were defaulting.
Roughly speaking, Brad DeLong opts for Proposition B. He thinks the problem is that too many fund managers simply accepted ratings as a gold standard instead of doing their jobs and asking the “three standard questions” that all investors should always ask. “If you truly do not want to ask the three standard questions and evaluate credit risk you should be in U.S. Treasuries (and even there you have to assess inflation risk and, unless you are planning to hold to maturity, monetary policy risk). And if you want higher yields than Treasuries offer — well, then you are back to asking your three standard questions again.”
Point taken. But I wonder if this is realistic. There are a very limited number of extremely smart people in Wall Street firms creating all these complex new financial instruments, and they’re very highly motivated to make them as impenetrable as possible. The average pension fund manager or county treasurer is simply never going to be able to analyze them in any serious kind of way. It’s easy to say they should, but that’s like saying that our schools would be better off if every schoolteacher had a PhD. Given the current state of the art in human nature, it’s just not going to happen.
So in reality, there’s a large class of investors who have little choice but to trust the rating agencies. And if rating agencies have a fundamental financial interest in colluding with their clients, then that collusion is almost certain to happen. It’s true that the agencies might also make innocent mistakes, but let’s face it: the incentives work strongly in the direction of making all those mistakes in favor of their banking clients, not the investor community. It’s possible, for example, that Moody’s genuinely didn’t realize that first and second loans combined were a better measure of debt stress than first mortgages alone, but that’s really not rocket science. It’s hard not to think that they weren’t trying very hard to understand the emerging new realities. As Upton Sinclair famously said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
So sign me up as a dissenter. Yes, investors are responsible for analyzing the risk of their investments. At the same time, when it comes to the kinds of investment vehicles routinely created today, the only realistic option a lot of investors have is to trust the advice of independent experts — ones who have their own staff of rocket scientists and access to all the underlying data that makes up a modern investment vehicle. If it turns out that those independent experts have enormous incentives to help the bankers game the system, that’s a problem. And right now we’re all paying a pretty big price for it.