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Discredited credit agencies

October 19th, 2008

I’ve done another guest post over at the ABC Unleashed site, on the topic, which we’ve discussed here a few times, of the ratings agencies, their quasi-official role in regulating investment, and their recent catastrophic failures. I’ve reposted it over the fold.

The present financial crisis is notable for the lack of high-profile villains upon whom blame can be pinned. There is no obvious Enron or Long Term Capital Management. Rather, the entire financial system has failed, and the checks and balances that were supposed to prevent such failure have proved useless.

Among the most prominent checks and balances are private sector ratings agencies, of which the most prominent are Moody’s, Standard & Poor’s, and Fitch. Although these agencies claim only to offer opinions, and therefore to fall under the protection of the First Amendment to the US constitution, they have long-held quasi-official status.

All sorts of bodies, such as local councils, are required by law, in Australia and other countries, to invest only in assets rated as AAA (or sometimes as A or above) by these agencies. In effect, we have outsourced a large part of our financial regulation to foreign companies that offer no guarantee of their own reliability.

As councils in Australia, and many others investors have found, relying on a AAA rating can be a road to disaster. For example, Wingecarribee Shire Council in New South Wales, operating under rules that specifically enshrined Moody’s and Standard & Poor’s ratings, invested in AAA-rated collateralized deposit obligations sold by Lehman Brothers. The investments were worthless, and the Council’s attempts to recover its money seem doomed, now that Lehmans itself is bankrupt. Thousands of AAA-rated investments and tens of thousands of investors have experienced similar outcomes.

There are a number of explanations for the failure of the ratings agencies. First, like most participants in global financial markets, they have shown themselves to be subject to the euphoria that is associated with a booming market, and the prosperity it brings to the financial sector. Second, they are subject to inherent conflicts of interest, since the issuers of financial securities pay to have them rated.

Third, and most importantly, they have a long-standing ideological bias against the public sector. This is reflected in the fact that state and local governments, which rarely default on their debt, are assessed far more stringently than corporate issuers. In the last year, thousands of private-sector securities issued with AAA ratings have been downgraded to junk, and many have subsequently gone into default.

By contrast, defaults on government debt have remained rare. One effect of the differential ratings practices of the agencies is that government borrowers have been forced to seek insurance from bond insurance companies such as AMBAC that are, in reality, less sound than the governments they are insuring.

In Australia, despite the fact that no state or national government has ever defaulted*, the agencies regularly threaten the withdrawal of AAA ratings if governments invest in infrastructure assets. One result has been the push to rely on private financing, through Public Private Partnerships (PPPs). It seems likely now that many of the private partners in these deals will fail, and that the government will be left to clean up the mess.

In the current environment, assessing the soundness of public investments, and certifying the security of public debt, is too important a task to be left to private firms. The Australian government should establish an independent body to undertake these vital regulatory tasks for the domestic markets. As part of the new financial architecture that must emerge from the current crisis, a similar body needs to be established internationally, through co-operation among central banks.

The ratings agencies have failed to do their job. If they can persuade private firms to overlook this failure, and take notice of their opinions, that is all well and good. But they should no longer be given the backing of governments, and their ratings should not be treated as relevant information for the purposes of financial regulation or public policy.

* As reader Tony G points, out the Lang government in NSW stopped interest payments on bonds during the Depression, but the Commonwealth stepped in and made the payments. From the point of view of bondholders, this episode shows that state governments are even better risks than their balance sheets would indicate.

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  1. October 21st, 2008 at 18:59 | #1

    To get the discussion down to brass tacks, what regulation would you like to see either introduced or re-introduced?
    Would it be as simple as adding yet another government department, this one charged with issuing bond ratings or what else? Quantitative controls? More prudential oversight? Stronger liquidity ratios?
    Why do you believe these would produce a better outcome?

  2. Chris Lloyd
    October 21st, 2008 at 23:00 | #2

    Andrew, I thought I made my main point which is that private ratings agencies have an incentive to under-estimate risk. You have stated that government rating swould be ‘exoensive, untimely and ineffective.” Well, it would have been pretty timely 12 months ago. An I ahve specifically argued it would be more effective. Expensive? I reckon the government would even make a profit (like Choice magazine).

  3. October 22nd, 2008 at 00:41 | #3

    Chris,
    The counter to that is that a government agency has an incentive to overstate risk – which, under normal circumstances, is likely to depress returns.
    The ineffectiveness comes from not being able to do much more than do ratio analysis from published reports. Any idiot person with a spreadsheet can do that. They are unlikely to be able to carry out operational reviews, interviews with the company officers etc. etc. that the current raters can do. If you can see how they are to be more effective, I would be interested to hear it. I believe that a government agency would also not have anything like the scope to cover enough issues quickly enough (remember, debt issues are generally time-limited) to give good spread to those relying on them.
    The untimeliness has largely the same source, but it would also do some good to look at the number of employees that the agencies have – they are big, multinational companies. Trying to get the number of analysts, and the level of ability, that they currently have would take considerable time and money. Here is the expensive bit – these people are not cheap – and the cheap ones, straight out of Uni, would be easy to get some of the dodgier issues past, leading to errornous output, and some losses.
    It is easy, currently, to laugh at them but, except for the exotic instruments that rely on models, the agencies actually normally do a good job. Historically, companies generally perform to their ratings. I have gone back through this for a lot of the risk work I have done.
    Have a good look at their history in rating government and companies. While they have proved to be in error with their ratings of many new instruments, in the areas they have been doing for years they are pretty right. Not perfect, but good.

  4. Tony G
  5. jquiggin
    October 22nd, 2008 at 05:42 | #5

    AR, I don’t have too much of a problem with the agencies ratings of corporate bonds. These have mostly been OK, though they did badly enough in the dotcom boom to undermine a case for regulatory reliance on their opinions.

    But once they go beyond corporate debt they have been actively pernicious, both because their ratings within classes have been poor and because they use the same rating scale even though it is obviously not comparable between asset classes.

  6. Eli
    October 22nd, 2008 at 22:21 | #6

    John,

    a couple of comments:
    - you seem to be arguing that the rating agencies are biased due to conflicts of interest and so on. However, the post seems to say that on the one hand they rate structured securities too highly (as has been demonstrated recently) and on the other hand public sector debt too lowly. I note in this respect that the conflict of interest you point out (being paid by the issuer of the securities) is the same whether the issuer is a company, a structured vehicle or a government and cannot therefore account for these perceived biases, on this logic, all ratings should be overstated equally.
    - The other explanation is the ideological anti-public sector argument which does not seem entirely convicing either. If the agencies enjoy quasi-governmental status as per opening paragraph, it is hard to see how they could at the same time maintain an anti public sector ideology. In any event, the evidence does not bear this out as any number of governments are indeed rated AAA/Aaa, including all Australian state governments. The low public sector ratings are in the main US municipal ratings, where the defaut history is rather more extensive…
    - Australian local councils were incredibly reckless in their investment choices. Relying solely on the rating is foolhardy and is in direct conflict with the intent of the rating which is meant to be a data point only.
    - As pointed out above, a government-run entity would have an inherent negative bias w/r/t ratings they may assign. The point is not to produce more conservative or more aggressive ratings but ratings which are accurate. Otherwise, you are mispricing risk either way and I do not see why overly negative ratings would be helpful.
    - All of which does not rule out the need for stricter oversight of the agencies and the need for transparency of their methodologies. This general point applies equally to the entire system…

    There is not any one (or two… or three) explanation for the mistakes made by the rating agencies in assessing sub-prime RMBS and CDO’s. It’s a pretty long list but a major factor is actually lack of resources: the agencies were simply swamped with securitisation work during 2004-2007 period, leading to more ratings per analyst, less time per transaction, less time to verify models and so on. Mistakes were made as the result of not having thought enough about big picture issues basically. We may say they should have taken whatever time and resources that were necessary but the reality during those years was that transaction timelines were short, and becoming ever shorter (and not as an isolated case where the agencies could and did push back but for the market as a whole), attracting talented analysts was becoming harder and harder (people ar rating agencies get compensated well but less well than the bankers they were having to push back against). The analysts they could hire were getting younger and younger with all the usual issues around lack of experience and skepticism. In the end, presure piled up and something had to give.

    All of this would only get only worse with a quasi-public rating agency, you would have less resources or talent still.

    Thanks.

  7. October 22nd, 2008 at 22:37 | #7

    PrQ,
    I would have to agree on the “actively pernicious” bit. This effectively states they have been guilty of conspiracy to defraud. This may have happened in the occasional individual basis, but the ratings and models are checked at several levels before any of them are issued.
    In this case I think it is that the models did not cope with the changes in the real world that eventuated. Liquidity (for example) squeezed more than the models’ inputs assumed it could and it has lasted for longer than they thought possible. This (IMHO) is a long way from being “actively pernicious”.

  8. Chris Lloyd
    October 23rd, 2008 at 13:42 | #8

    Andrew,

    Let’s keep the outsourcing of restaurant health inspections as a test case. Substitute risk for healthy and security issuer for restaurant anywhere you like. The problem is that it seems to me that your objection could equally be made to the (apparently unchallenged position) that health inspections should be done by government.

    You say it would be too costly. My response would be it is less costly to society than not having proper health inspections. Or do you prefer to have private health inspections, or no health inspections and let dirty restaurants be discovered by word of mouth and death by food poisoning?

    You are concerned that “they are unlikely to be able to carry out operational reviews.� It will be a condition of being rated that you make full disclosure and any deliberate deception is an offense. By way of contrast, what kind of data do you think issuers make available to S&P? Most likely the information given puts the security in the best possible light, risk is hidden, the parties wink at each other and some poor sod buys the security (walks into the restaurant).

    Government rating would all of a sudden become very popular if it was made law that (a) the four banks, (b) insurance companies, (c) super funds, (d) future fund were banned from investing in non-government rated assets. The rationale would be that otherwise they could not be properly assessed for prudential compliance.

    And “government agency has an incentive to overstate risk� Pure assertion on your part but it wouldn’t matter anyway, so long as the ranking of alternative investment risk was correct. Any systematic tendency to over-state risk would eventually be adjusted for by the market. To put is more imply, if health inspectors never gave AAA health ratings to any restaurant then people would not stop eating out. They would quickly realise that AA is really the top rating.

  9. James Haughton
    October 23rd, 2008 at 15:49 | #9

    quotes emerging from various hearings today:
    Standard & Poors Officials on a mortgage backed security deal:
    “Official #1: Btw (by the way) that deal is ridiculous.
    Official #2: I know right…model def (definitely) does not capture half the risk.
    Official #1: We should not be rating it.
    Official #2: We rate every deal. It could be structured by cows and we would rate it.”

    Executive from Moody’s:
    “These errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue.”

    Still not “actively pernicious”?

  10. tin tin
    October 23rd, 2008 at 16:25 | #10

    Wow! Times have changed. Even Ayn Rand acolyte Alan Greenspan is calling for tougher regulation of the financial sector. Story below.

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

  11. Eli
    October 23rd, 2008 at 18:13 | #11

    James,

    off-the-cuff comments by overworked and cynical analysts at rating agencies are neither here nor there. They do get a a lot of fairly superficial media attention though, at the expense of careful analysis.

    The central issue is that the rating agencies – along with a large number (ie. the majority) of other market players – made soem serious errors in rating some of the more complex debt instruments. The question now is how to correct the system so that this type of error is avoided in the future. Eliminating rating agencies is not the answer, that would simply lead to even more opaque markets. Government-run agencies is not the answer either as I mention in my earlier post. So, we are left with a greater degree of scrutiny externally, hopefully accompanied within the rating agencies themselves with a shift in focus from a model-based approach to common sense and a better grasp of the big picture. Appropriate resourcing is the other part of the answer (Moody’s was shown in the House of Rep hearing to have had the highest profit margin of all S&P 500 companies for the past five years, this is not due to their amazing profitability but due to underresourcing).

  12. Eli
    October 23rd, 2008 at 18:18 | #12

    Chris Lloyd,

    let me take this up. Part of the issue is that rating debt instruments is much more complext than health inspection, and quality of such ratings is directly linked to the talent employed by the agencies. The government would not be able to do attract the appropriate talent. The basic example here is APRA which is notorious in the local market here to regularly miss significant structural weaknesses in their reviews.

    Mandating governments ratings as you suggest is fraught. The basic problem is that any kind of mandated ratings provides an incentive to those institutions to not undertake their own analysis. Over reliance on external ratings is a major part of the problem and we would be wise not to worsen the situation.

  13. jquiggin
    October 23rd, 2008 at 18:33 | #13

    “off-the-cuff comments by overworked and cynical analysts at rating agencies are neither here nor there.”

    But in this case the off-the-cuff comments were far more accurate than the official ratings S&P subsequently issued.

  14. TerjeP (say tay-a)
    October 24th, 2008 at 22:07 | #14

    Wayne Swan has moved to ensure that the credit rating agencies won’t become unemployed.

    http://www.theaustralian.news.com.au/story/0,25197,24546412-601,00.html

    But the system will be optional, with the decision to take the guarantee resting with the financial institution.

    The amended guarantee system will also be extended to wholesale funding with the fee to be based on the eligible institutions’ credit ratings.

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