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After the ratings agencies

March 8th, 2008

Among the likely casualties of the emerging financial crisis, the ratings agencies (Moody’s, Standard & Poor’s, Fitch) have to be near the top of the list. The crisis has exposed fundamental weaknesses in the way in which ratings are determined and adjusted. The privileged position held by these agencies can no longer be justified. it’s far from clear how these problems could be resolved, but I’ve set out some tentative thoughts below.

First, as the crisis has shown, the much sought-after AAA rating is virtually meaningless in itself, as is the “investment grade” rating below which securities are classed as “junk”. For some asset categories, like government bonds, it means default is virtually unthinkable. For others, like mortgage-backed derivatives, it says that, default is unlikely, provided that the assumptions used in constructing the derivatives, based on perhaps five years of data, remain valid. Translated that means the probability of default is somewhere between 0 and 100 per cent. Vast numbers of such securities have been downgraded from AAA to junk in the last year, and all are appropriately regarded as being in the “jun” (that is, speculative) category.

This produces some absurd results. For example, Ambac, a mortgage insurer whose shares have lost 92 per cent of their value in the past year, is rated at AA by Fitch. By contrast, Greece, a Eurozone member country, is rated A. Does anyone seriously think the probability of default by Greece is greater than that for Ambac? And Fitch is conservative. Moodys and S&P still have Ambac rated as AAA suggesting, to anyone foolish enough to believe them, that the probability of default is negligible.

State and municipal governments are beginning to rebel against the system of discrimination under which municipal bonds get rated around six grades lower than corporate bonds of comparable quality. That’s the estimate of the agencies themselves – the reality is far worse. As the NYTimes notes, “since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings.”

Again from the NYTimes “. Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things.” But lots of organizations are required by charter or legislation, to invest only in AAA, or only in investment-grade securities, and lots of funds advertise to retail customers that they invest only in AAA-rated securities. Fairly clearly, such requirements are inconsistent with the fiduciary obligations they are supposed to enforce.

What could replace reliance on ratings agencies? For those who want a reasonably secure guarantee against default, the best advice at present would be to restrict investments to those with an explicit guarantee from a developed-country national or state government. An obvious implication is that states would need to guarantee, or borrow on behalf of, municipalities and agencies. This is already done on a substantial scale for example by Queensland Treasury Corporation.

Looking at the corporate sector, it’s pretty clear that restoring the credibility of ratings agencies will require a lot of improvements to independence and transparency. The situation under which securities issuers solicit ratings from agencies is one obvious problem. So is the willingness of agencies to rate complex securities based on limited modelling.

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  1. Mitch Guthman
    March 17th, 2008 at 12:36 | #1

    Swio puts his finger on the real nub of the current problem: The market was pricing in risk—-that was the job of the rating agencies for the quite obvious reason that it is uneconomical for individuals or even banks and brokerage firms to gather and analyze enough reliable data even if they had the expertise to make intelligent use of it. Again, that’s why the rating agencies were given their special quasi-official status.
    So here’s the problem: Once they began to allow bank holding companies and similar financial institutions to put so much of their risk off of their balance sheets and to rate bonds/SIV’s/CDO’s etc based on some mathematical analysis of the risk of future default, lenders went right back to the reckless patterns which they had established in the cowboy era of Long Term Capital. The Carlyle fund that went down apparently had a gearing ratio of 32-1. It must have been clear to the lenders that even a miniscule movement in the underlying securities would result in an immense potential loss which probably can’t be hedged or undone.
    Same with counter-party issues: Bear guaranteed probably billions of dollars of loans, swaps, etc. How could it possibly hope to survive any major shift in the market? It couldn’t but while it was waiting for that to happen, it could and did pay massive “bonuses� in acknowledgement of the great leadership of the people who wiped out their own firm. And I will bet any amount you care to name that Bear’s board won’t try to claw back a penny its ever paid to the CEOs who steered their own firms onto the rocks. Same with Citigroup and ML.
    So, basically, since there are no honest ratings being produced by the ratings agencies, there is no longer any way for the market evaluate risks and set prices accordingly.

    Warren Buffet was right: Derivatives are financial weapons of mass destruction.

  2. Tony G
    March 28th, 2008 at 22:47 | #2

    “California Treasurer Bill Lockyer is leading more than a dozen state and local governments that say bond ratings exaggerate the risk of default, pushing up interest costs and forcing issuers to buy unneeded insurance.”

    “Lower-ranked munis performed better than the best company bonds. Corporate debt with Moody’s highest rating had an average 10-year cumulative default rate of 0.52 percent between 1970 and 2006, compared with 0.13 percent for munis carrying the fourth- highest rating.”

    http://www.bloomberg.com/apps/news?pid=20601109&sid=aRgAaao03hI4&refer=home

  3. April 2nd, 2009 at 07:47 | #3

    The People’s Bank of China is on the case:
    “Central banks and regulators should impose [a] requirement whereby use of external ratings should not exceed 50 percent of business activities, at least for systemically important financial institutions. Internal capabilities should be developed to exercise independent judgment on credit risks at such organizations.”
    Apart from the self-congratulation (oligarchy works!) at the end, it’s a pretty good piece.

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