Home > Economics - General > After the ratings agencies

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. Ikonoclast
    March 8th, 2008 at 20:38 | #1

    All of which demonstrates what a corrupt mess the US financial system is. They have shot themselves in the foot big time this time round.

    The “perfect crash” is coming. Shame it’s in our lifetimes huh?

  2. mugwump
    March 9th, 2008 at 04:15 | #2

    The solution is to get rid of the effective government-granted monopoly on ratings providers. The ratings used for banks, money markets and state pension funds must be assigned by Nationally Recognized Statistical Rating Organizations, or NRSROs.

    In order to achieve the NRSRO designation, and organization must be “nationally recognized as an issuer of credible and reliable ratings by the predominant users of securities ratings.”

    So you effectively cannot become an NRSRO unless you’re already an NRSRO. Catch 22.

    Up until the latest crisis there wasn’t much impetus to change the designation rules because the system worked pretty well and made boatloads of cash for the big rating agencies. However, with the recent failures by the ratings agencies, now is the obvious time to open up the ratings business, and let the chips fall where they may.

  3. March 9th, 2008 at 06:30 | #3

    OT comment deleted – as I said Al, there’s nothing to do but stick to the topic at hand – JQ

  4. March 9th, 2008 at 08:06 | #4

    mr q, my post was as relevant, and more pointed, than ike’s. perhaps less comfortable?

    Unfortunately, al, you’re on probation for monomania. Leave commentary on the general corruption of modern political systems to others for the time being

  5. Ikonoclast
    March 9th, 2008 at 10:13 | #5

    Self regulation never works. The goverment must regulate citizens and corporations by legislation and the citizens must regulate the government by democratic elections.

    Corporatists and capitalists cannot be trusted to self regulate. Along with unions, workers, guilds and club committees who also cannot be trusted to self regulate. Sectional interests always work away to try ro corrupt the system in their favour. As Adam Smith said, “Every profession is a conspiracy against the public.”

    Finacial regulation must be fully and firmly in the hands of the goverment and fully government controlled though a semi-independent Reserve Bank. The US effectively has privatised financial regulation and OMG what a mess it is as we can see.

  6. March 9th, 2008 at 11:45 | #6

    ike, self regulation is immensely popular, and works very well, from some points of view. which point of view will prevail is the question. the answer will be decided.

  7. swio
    March 9th, 2008 at 14:55 | #7

    Why doesn’t the market just regulate bond risk through pricing? I don’t understand the need for ratings agencies. Is there some reason that market buyers can’t make their own assessments of default risk and bid the price appropriately? What are all these highly paid finance people doing if the process of risk alloctation consists of looking up the rating in Moody’s? A trained monkey could do that.

  8. Fred Argy
    March 9th, 2008 at 16:58 | #8

    John, the collapse of trust in ratings agencies adds another serious element of uncertainty. My main worry is what is happening to AAA financial institutions.

    The risk premium that some banks are paying to borrow indicates a loss of confidence in our whole financial system. There is a very grim report in the Weekend Australian by Adele Ferguson (no link, sorry) which, while I feel it is very over-drawn and alrmist, will scare a lot of people on the degree of off-balance sheet exposure of banks to the derivatives market in all its current complexity.

    Such reports, coupled with lack of transparency and fear of the unknown is weakening one of the pillars of our financial system. I believe it is time for APRA and RBA to start reassuring small investors that banks are completely safe and that their balance sheets do not conceal un-revealed risks. Or do something about it.

    How ludicrous that the RBA is blissfully raising interest rates in this climate.

  9. Socrates
    March 9th, 2008 at 18:04 | #9

    Forgive my ignorance on this one but is there anywhere that a government agency or Qango does this wel on a fee for service basis? I coulnd’t help but think that if the RBA already assesses the prudential equit of banks now anyway, why couldn’t the same section assess these risks? They could probably charge half of what S&P charge and still make a profit, so is this a solution?

  10. March 9th, 2008 at 18:25 | #10

    just as a matter of theoretical interest, if some regulatory agency has access to the daily financial activity of any large corporation, can it predict success or failure in the market?

    if it can’t, how then can rating agencies succeed? if it can, shouldn’t this information be public?

    and of course, if the information is less than total, isn’t this whole activity nearly meaningless? worse than meaningless, really: isn’t the purpose of these rating agencies merely to shill for capitalism?

  11. March 9th, 2008 at 18:31 | #11

    The problem with that approach is that institutional investors use investment policies, and those policies need a simple method of indicating risk for policy use.
    The bigger players in the market know the problems with the ratings and generally only use them as a guide and for policy formulation. They also tend to try to put together arbitrage plays based on the differences between the ratings agencies and the markets, for example.
    The should only be used as a shorthand anyway – another useful tool. Like anything in any market it is all just information in the mix. As mugwump pointed out the real problem is if people (typically regulators) try to use them as anything else. They are an opinion – typically a well informed one, but an opinion nevertheless.
    Using them for regulatory purposes (as, for example, Basel II does) is at best lazy and at worst dangerous.

  12. swio
    March 9th, 2008 at 18:48 | #12

    Thank you Andrew. A follow up question, are there any government regulations in Australia tying financial institutions to them to specific ratings agencies, or is the use and choice of ratings agencies entirely at the discretion of the financial institutions themselves?

  13. Joe
    March 9th, 2008 at 19:16 | #13

    Moody’s is a very political organisation: “The combination of the medical programmes and social security is the most important threat to the triple-A rating(of the US Government) over the long term,â€? see Mark Thoma’s article

  14. March 9th, 2008 at 19:31 | #14

    For banks and other ADIs following that “standardised” approach to Basel II compliance (all of them other than the big 4, BankWest and St. George) APS 112 allows their use, but does not require it. In practice, though, the smaller banks and ADIs are not normally lending to rated entities.
    APS 116 for market risk, though, does use them extensively and this is where US contagion risk is more possible – but again, not many Oz smaller ADIs typically buy US paper.
    Insurance is not my area, but I believe similar rules apply there, with the riskiness being assessed (where possible) through the use of ratings.
    Interestingly, the Oz regulators have effectively outsourced accreditation of ratings agencies by using the US NRSROs for this purpose. They theoretically could allow the use of others, but they do not.
    ASIC also require prudential policies from most funds managers and super funds, and most of these reference the ratings agencies’ ratings. These are not required, but ASIC normally requires a risk profile be developed, and most of these include things like “investment grade” i.e. use the ratings agencies.
    The topic could be a long one, but that is a brief summary.

  15. Ian Gould
    March 10th, 2008 at 00:32 | #15

    A few thoughts on how to improve the situation.

    First up, allow new entrants into the ratings business.

    Second, make the potential downside from poor ratings greater- make it easier for investors who lose money to sue the ratings agencies.

    Thirdly, and most importantly, break the connection between the issuers and the ratings agencies. Instead of or in addition to the issuers hiring the ratings agency of their choice, require exchanges to pay for multiple ratings on securities they list from a panel of ratings agencies.

    This leaves the unlisted securities which in the bond market are probably the majority. Perhaps the bond underwriters and insurers should be liable to choose the ratings agencies in those cases.

    In all cases, the money will ultimately come from either the issuer or the buyer, but interposing a third party will at least make it harder for issuers to lean on ratings agencies.

    Personally I subscribe to the view that markets are generally better (albeit for from perfect) than ratings agencies in assessing risk and fair value.

    I know the current mood is heavily against securitisation but I think many of the problems arise not from the basic principle but from narrowness and illiquidity of the markets in question.

    The question is how we can overcome those structural problems.

  16. swio
    March 10th, 2008 at 00:44 | #16

    Sounds like if there are going to alternative to the US ratings agencies it will require a combination of new or less restrictive government regulation to make it easier for financial institutions to use alternative and less well established ratings agencies. The only three places I can think of where that could happen are the EU or, in Asia, Japan and Singapore. Everywhere else lacks an effective regulatory framework. It will be interesting to see what the EU does. They have an incentive to change the system as more realistic ratings would directly reduce the borrowing costs of member governments.

  17. jquiggin
    March 10th, 2008 at 06:31 | #17

    #mugwump at #2. Since I’ve complained repeatedly about the nature of your comments, let me note that this is an exception. You make a substantive point, bringing new information, and without snarky attacks on anyone. If you would stick to this kind of thing, you would be much more appreciated, and you might even convince people.

  18. March 10th, 2008 at 11:04 | #18

    The reason why most of the NRSROs are from the US (not all – one is Canadian) is simple. They have a large and deep market for such paper (bonds mostly). The US market dwarfs all others by a considerable margin. Most other countries still rely heavily on bank debt, so the amount of tradeable debt is quite low.
    Unless and until this situation changes you cannot expect any other jurisdiction to develop an SRO of any size.
    Ian Gould,
    The only real way to address the scale problem you identify is to increase the markets for debt. In Australia it would help if tradeable debt was not more expensive than bank loans (check out stamp duty, other imposts and the other difficult regulatory burdens) and that more people wanted to buy it (similar issues).

  19. March 10th, 2008 at 12:15 | #19

    Ikonoclast – at comment #5 you make an amazing generalisation in suggesting that corporations can never be trusted to self regulate. We currently trust the vast majority of companies and businesses to self regulate eachother on price by virtue of competition. To the extent that we invoke government regulation in regards to price it is an exception not the norm. I find the form of unjustified absolutism that you are spouting to be rather dismal.

    Self regulation as I understand the term does not mean trusting individuals to selflessly look after the interests of others at their own expense (although this also sometimes happens). As I understand it the term means to allow non-government factors such as competition, reputation, public relations and industry structure to mitigate abuse, coruption and incompetence. You seem to suggest that democratic voting for a bundled political package is the only method with any effect. I’d argue that it is one of the bluntest and weakest of instruments although obviously expedient at times. The content of comment #2 would also suggest that democratic voting for a bundled political package also routinely leads to myopic and disfunctional regulation.

    Do you routinely start from the assumption that government intervention is best? I think you over rate the efficacy of violence and coercion because these are the only unique qualities that government can ever bring to the table.

  20. swio
    March 10th, 2008 at 13:45 | #20

    I see your point, but is it perhaps a case of the chicken and the egg? Is perhaps true that in part Europe lacks deep liquid bond markets because it doesn’t have its own SRO’s and it lacks SRO’s because it doesn’t have a big bond market? With the current freezing up of the US credit markets it might occur to other jurisdictions to create their own version of each so they can insulate themselves from American problems. There are certainly enough funds in Europe to make it happen.

  21. pommygranate
    March 10th, 2008 at 18:48 | #21


    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

    Have you forgotten South Korea in 1997, Russia in 1998.

    The agencies have made a huge mistake in valuing CDOs of mezzanine mortgage debt. It turns out that if you take the risky piece of hundreds of mortgages and stick them into a pot, the pot is still risky. But to be fair, very few highly paid Wall St analysts saw it either. In fact only the traders at Goldman Sachs spotted their mistake and reportedly made $3bn on the back of it.

    In general, the agencies function very well. The reason is reputation risk. As soon as markets believe an agency is asleep, they will ignore these ratings and the issuers will stop paying exorbitant prices to rate their debt.

  22. Ikonoclast
    March 10th, 2008 at 19:44 | #22

    In response to Terje at 19. Humans are guided by self interest. Adam Smith said as much. The discipline of the free market is a kind of regulation as you say. But it is not self-regulation. It is inter-dependent and competitive regulation.

    However, the “free market” so called has always been bedevilled by market failure of various types. The entire market system requires regulation and moderation if social doemcratic goals are to be achieved.

    I’ll give one example. We are now at a point where over-production and over-consumption (in the West) is about to wreck our world irreparably. Yet the world advertising industry – a trillion dollar industry I would say – is still exhorting us to consume more and more. It is time to regulate the advertising industry much more stringently than is currently the case.

  23. Ian Gould
    March 10th, 2008 at 22:58 | #23

    Thinking further on this over the last day or so I’m now wondering if perhaps the definition of “sophisticated investor” needs to be tightened up.

    Sophisticated investors are the financial institutions, merchant bankers, hedge funds and high net worth individuals allowed to invest in relatively risky products such as unlisted shares and collaterlaised debt instruments.

    Maybe these investors should be limited in the amount of leverage they can take on and required to demonstrate that they have sufficient liquid prime assets to meet any margin call. (I.e. if you want to borrow $100,000 to invest in CDO maybe you need to have $100,000 sitting in bank account.)

    Yes, I know this could be seen as contradicting my previous comment about the need to increase the dept and liquidity of the markets.

  24. SJ
    March 10th, 2008 at 23:26 | #24

    Ian, the term “sophisticated investor” already has a definition under Oz law, that definition being:

    Sophisticated investors

    (8) An offer of a body’s securities does not need disclosure to investors under this Part if:

    (a) the minimum amount payable for the securities on acceptance of the offer by the person to whom the offer is made is at least $500,000; or

    (b)the amount payable for the securities on acceptance by the person to whom the offer is made and the amounts previously paid by the person for the body’s securities of the same class that are held by the person add up to at least $500,000; or

    (c)it appears from a certificate given by a qualified accountant no more than 6 months before the offer is made that the person to whom the offer is made:

    (i) has net assets of at least $2.5 million; or
    (ii) has a gross income for each of the last 2 financial years of at least $250,000 a year.

    What you’re really asking for is tighter regulation of NBFIs (non-bank financial institutions), rather than “sophisticated investors”.

    Note that I’m not saying that there’s anything wrong with the argument you’re making.

  25. SJ
    March 10th, 2008 at 23:31 | #25

    …with the argument you’re making insofar as it applies to NBFIs.

    (I wish there was a preview function here).

  26. Ian Gould
    March 10th, 2008 at 23:40 | #26

    SJ, actually it’s more an argument that the requirements on sophisticated investors, at least those who invest in some asset classes, need to be tightened up.

    Specifically there’s a difference between “net assets” where such assets include illiquid assets like property (and for that matter holdings of exactly the sort of assets we’re concerned about)and
    prime assets such as deposits with an ADI.

  27. Tony G
    March 11th, 2008 at 01:04 | #27

    “sophisticated investor�

    “Berkshire has brought in $3.2 billion in premiums for insurance against the default of some high-yield (‘junk’) bonds. Bary writes, “Memo to Buffett watchers: The Great One seems increasingly bullish about depressed junk bonds” and he calls Buffett “one of the sharpest investors in junk debt” even though he doesn’t always get a lot of credit for his talents in that area.”



    Maybe Buffett should do the ratings.

  28. PeterC
    March 11th, 2008 at 07:26 | #28

    Ikonoclast: I think you’ll find it was George Bernard Shaw, not Adam Smith, who wrote: “All professions are conspiracies against the laity” [from 'The Doctor's Dilemma'].

    Smith did say something very similar when he wrote [in 'The Wealth of Nations'] that: “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

  29. March 11th, 2008 at 11:03 | #29

    I would agree. The problem, historically, is that debt issue was (you guessed it) highly regulated and taxed. This is going, but the effects of such strictures remain. The small markets in the EU mean that US issues are considered better. This is changing with the Sarbanes-Oxley regs in the US, but rule 144A private placements are still popular, and mean that the SOx regs do not apply.
    People are not sheep led around by the nose by the evil, malevolent advertising industry. Like most advocates of regulation you seem to think that you alone can see clearly the fate of the world and that the lumpen proles are stupid and need to be led. Such arrogance really belongs in a different age – or even political category.
    I do not believe you meant it to come out that way, but I think it needs to be pointed out to you that this is how it looks.
    That can only be effective against the public over any more than the very short term with the aid of regulation.
    The professions, like the merchants guilds and others before them, are only able to protect their privileged positions by the use of the regulations you are trying to use to stop them doing so.
    Lawyers are a great example – why can’t I represent anyone other than myself before the courts? Regulation. The only reason lawyers can charge so much for their time is that they get to choose who to admit to the Bar – and this is enforced by regulation. It is regulation that is the problem, not the solution.

  30. Ernestine Gross
    March 11th, 2008 at 12:55 | #30

    After the rating agencies there may be a renewed interest in education aimed at developing indenpendent minds, reasoned judgements, and personal responsiblity. And, an interest in JQ’s paper on the role of goverments in risk management may become ‘in’.

    With a bit of luck, the whole ‘Total Quality Management’ buraucracy will be considered ‘out’, together with such heroic notions as ‘world best practice’, ‘world class’, ‘league tables, and ‘KPIs’.

    Incidentally, ‘evidence based’ decision making can mean different things. For example, financial managers of other people’s money who base their decisions on rating agencies may claim their decisions are based on evidence.

    Another incidentally: Where were the promoters of v. Hayek in warning people about rating agencies? On the ocasion where v. Hayek’s work on the role of information in an economy is relevant they were notable by their absence.

  31. March 11th, 2008 at 13:17 | #31

    The supporters of Hayek in the market were making a lot of money arbitraging against the silly government intervention that was driving the adverse behaviour. Have a look at Goldman’s results for example. They were smart enough to spot the hole and play against it. Personally, I have had little exposure to the markets (short or long) for a while. Much of the regulation and interference has been causing these issues, Ernestine – more regulation and interference from those arrogant enough to think they know better I do not see as solving the problem. Quite the reverse.

  32. Ernestine Gross
    March 11th, 2008 at 13:30 | #32

    Andrew (Reynolds), I don’t understand your comment. My point reference to v. Hayek pertains to the rating agencies. In your opinion, are these agencies part of ‘the market’?

  33. March 11th, 2008 at 13:56 | #33

    Of course they are – they are an informational input into the market and many participants in the market use that information in their trading activity. Their importance has been overblown by their incorporation into regulation, but they are participants (through the provision of information) in the market.
    I have (elsewhere) frequently made the point that over-reliance on these ratings is silly, and that using them for regulatory or policy purposes was at best lazy – for recent examples see up the thread (11 and 14).
    The simple fact that huge piles of money were chasing assets simply because they had to invest in paper with certain ratings was enough to drive this behaviour. Those who had noticed this, and were not so regulated, made a lot of money out of shorting those positions.
    If you dive into the literature on the subject in the period 1998 to 2003 and after when Basel II was being developed you will see plenty of examples of opposition to using these ratings for regulatory purposes.

  34. Ernestine Gross
    March 11th, 2008 at 14:55 | #34

    Andrew, thanks for your reply.

    1. My point was about v. Hayek and rating agencies: Rating agencies collect and bundle financial information. This activity is akin to that required by a strict central planner. V. Hayek said, in so many words, that this does not work.

    2.The time to ‘apply’ the one insight for which v. Hayek is acknowledged in mainstream economics was at the time when v. Hayek was ‘used’ to promote ‘deregulations’ (1980s). I don’t recall anybody having commented on rating agencies then.

    3. You talk about regulation. To the extent that you have in mind the growth in regulations of the type ‘how to do up your shoelaces’, I tend to agree with you. But there seems to be a demand for such prescriptive stuff and there is no lack of supply of this stuff either.

    4. As indicated in my comment, I believe the content of JQ’s article is more fruitful. Some rethinking on what risks are best managed by governments (directly) and what risks are to be borne by individuals and enterprises, is called for.

    IMHO, I believe a change in higher ed, away from training and outcome oriented, and toward the objectives I named, seems to me to be a co-requisite.

  35. March 11th, 2008 at 15:16 | #35

    I suggest that you re-read both Hayek and any ratings agency report. Any report will do. That, and the application of careful thought, will clear up your misunderstanding at 1 better than I can ever do.
    2. Ratings agencies were not commented on then as they were (generally) not used in regulations then. This has changed.
    3. The fact that some people like to be able to blame the government for their own errors does not mean that the government should be attempting to satisfy that demand and, by so doing, make the errors worse and longer-lasting. A government has a unique ability in a market – the power to compel. IMHO it is a power that is vastly over-used.
    4. I completely agree. My own belief is that the government is attempting to bear too much risk at the moment and government policy should be to reduce that burden, if possible to nil.

  36. Ian Gould
    March 11th, 2008 at 15:35 | #36

    Andrew, you continue to misunderstand Ernestine’s point.

    One of Hayek’s key points was that given incomplete knowledge, central planning can never work.

    Ernestine’s point is that rating agency’s (especially I’d suggest when rating countries) also run into the problem of incomplete information.

    Had the present day disciples of Hayek taken more from his work than “government is evil”, they might have realised that.

  37. March 11th, 2008 at 15:53 | #37

    With respect, I don’t believe I did miss the point. Information is always incomplete, and the ratings agencies (and other market participants) would be the first to acknowledge that. In fact, all ratings reports are issued with disclaimers and much other information in the body of the report that make their understanding of that clear. That was why I was encouraging Ernestine to actually read one – any of them – before continuing that line.
    Ernestine’s point at 1 above was that this was “akin to that required by a strict central planner” was, IMHO, wrong on that basis alone. They are prepared on a completely different basis. Strict central planners tend to implicitly assume they can plan the future. Ratings agencies do not. They have nothing to do with planning and everything with risk.
    When the regulators start to use them to try to reduce the difficulty of regulating then you get problems. IMHO the agencies should not be blamed for that – regulators and the regulations should.

  38. Will
    March 11th, 2008 at 17:03 | #38

    I think the problems with ratings and ratings agencies is a fundamental one.

    Ratings are single metrics that purport to represent probabilities of default. The use of external (agency) ratings by regulators or investors must, therefore, imply one of two things.

    One, that the external ratings represent some kind of objective probability. Or two, that the probabilities represented by the ratings are subjective – personal to the rating agency – but that the regulators and investors are happy to rely on them.

    The former, that they are objective, is easy to dispose of. If anyone can show that a probability assigned to the outcomes of an economic process represents some underlying physical reality, then please accept your Nobel now.

    The latter, that the probabilities represented by the ratings, are subjective and personal to the rating agency, raises a very serious question about the abdication of responsibility by regulators and investors. I don’t think it is controversial to say that if you are investing in assets, or you are attempting to regulate those that are, then you should form your own subjective assessment of the probabilities of various outcome, based on your own information and in your own context.

    Ratings agencies can be useful in the sense that they might generate very useful information that can contribute to the subjective assessment made by the investor/regulator. But that is certainly not the same as the totally unjustified “certification” of credit risk, akin to its commoditization, that seems to be the case in todays markets.

  39. Ernestine Gross
    March 11th, 2008 at 17:50 | #39

    Ian, my point excactly.

    Will, I concur with a lot of what you say. But I have yet to find a non-managerial reason for the existence of rating agencies. If rating agencies would take the financial responsibility for their output then it might be a different matter. The present time is a good one to test that.

  40. Ikonoclast
    March 11th, 2008 at 20:22 | #40

    For Andrew Reynolds at comment 29. So you disagree with regulation? This means you think any and all weapons should be freely on sale at every gunshop; every drug should be on sale at every street corner; anyone can hang out a shingle saying they are a brain surgeon; nobody should need a licence to drive a car; the financial world requires absolutely no laws governing it all etc. etc.

    Oh hang on… do I detect you do believe in regulation but only of the kind that you think necessary?

  41. Will
    March 11th, 2008 at 21:07 | #41

    Ernestine, A rating agency that took financial responsibility for its output would be one that actually invested money, and so would be indistibguishable from a bank (if regulated) or fund manager if not!

  42. Ian Gould
    March 11th, 2008 at 21:18 | #42

    Will, alternately you might consider my suggestion of making it easier to sue ratings agencies when they get it wrong.

  43. Ernestine Gross
    March 11th, 2008 at 22:44 | #43

    Will, I had something like a ‘money back guarantee’ in mind. Car manufacturers replace sold cars if they are found to be defective during a pre-specified period. To me this means the car manufacturers take the financial responsibility for the quality of their output. I thought my comment fitted your concerns about ‘commodification’ quite nicely in so far the rating agencies ‘produce’ information and the idea of ‘commodifying information’ doesn’t work (this includes education). JQ mentioned reputation. But, to the best of my knowledge, the reputation argument doesn’t count very much in the commercial world unless there are serious financial penalties for the decision makers (‘boiling in oil’ type penalties).

  44. March 11th, 2008 at 22:46 | #44

    So – if we are going to argue from absurdity, perhaps yuo would like to see the amount of air we breathe in a day regulated. Grow up and argue sensibly. Sticking to the topic would be a good start.
    You are completely free to sue the agencies if you believe you can establish grounds – negligence or malice would be good grounds. You can’t sue them if they are honestly wrong, just as you cannot sue your bank manager if she advised you to take out a floating rate mortgage, unless she was careless or malicious.
    As Will correctly pointed out, the ratings agencies assign probabilities of default (actually ratings that can be mapped to probabilities) – based on their opinion of such things as financial strength, internal controls and managerial competence and ethics. Most of the time they get it right. For long periods AAA rated securities experienced almost no defaults at all. They may have got the ratings on a new class of securities wrong. Well – it happens. With the wisdom of hindsight it is easy to say that handing out AAA or AA or even A ratings to these instruments was probably inappropriate.
    They, like we, live and learn. The problem is that many have grown to rely on these and follow them like a herd of sheep, blindly trusting the ratings agencies as if they were some form of omniscient market participant. They are not – and they would be the first to admit it.
    Use them like they should be – another source of information. They get some privileged information, but like auditors or anyone else they can be given a snow job or just get it wrong. They can also be negligent or malicious – like anyone else. Deal with it.

  45. Will
    March 11th, 2008 at 23:00 | #45

    Ernestine, A rating agency will never give any kind of guarantee for their ratings. They are very, very clear that they give opinions only. It is the way that the ratings are relied on that is the problem, I think, and that is really the problem of the investors and regulators, not the agencies themselves.

    In any event, how would you prove that a default on a A-rated bond was not just the 1/1,000 per annum chance that the rating implies?

  46. Ian Gould
    March 12th, 2008 at 00:43 | #46

    Another thought: would a British market-maker model be more appropriate for highly illiquid markets than the more common open outcry system?

    (In the market-maker system, one or more brokers continue quote buy and sell rates for an instrument and they are required to honor all offers to buy and sell at their quoted prices.)

  47. March 12th, 2008 at 11:08 | #47

    The market maker system works well – until the market maker no longer wants to make a market. I was on a trading floor in London when that happened for a while in 1997. A lot of phones just did not get answered that day. The market makers literally went out to lunch and did not come back.
    An electronic system may get around some of that, but websites are known to crash on the odd “inconvenient” day.

  48. Ernestine Gross
    March 12th, 2008 at 11:39 | #48

    Will, yes, rating agencies can be said to belong to the public relations industry of the ‘global economy’. This makes your second statement redundant.

    Your second statement nevertheless raises a question: Why would a security as described by you be called a bond rather than equity?

  49. March 12th, 2008 at 13:32 | #49

    Hardly, Ernestine. Their business is not concerned with anything other than rating financial instruments. If others choose to use it for other purposes that is up to them.
    With your second question – are you honestly saying you do not understand he difference between a bond instrument and an equity instrument? Quite a few blend the two, but the ultimate difference is pretty clear.

  50. Ian Gould
    March 12th, 2008 at 13:57 | #50

    Another thought, during the current crisis, would there be any benefit in temporarily permitting US greenshoe-style intervention by bond underwriters?

    (I.E. let the underwriters buy back bonds on market to improve liquidity and market confidence.)

  51. Mitch Guthman
    March 17th, 2008 at 12:36 | #51

    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.

  52. Tony G
    March 28th, 2008 at 22:47 | #52

    “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.”


  53. April 2nd, 2009 at 07:47 | #53

    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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