Quote of the day
Robert Waldmann
Felix Salmon wrote
“S&P and Moody’s are clearly completely incompetent, and no one should base any investment decisions on the random series of letters they apply to bonds.”
second quote (from comments)
“… But without rating agencies…… who other than big investment companies/funds that have their own in-house muscle to do due-diligence can buy these things?”
Posted by MarshalN
My thoughts after the jump.
So what’s the alternative to the random series of letters they apply to bonds? I see two possibilities.
1) a public ratings agency (not a public option mandatory public rating required for all regulatory purposes). Have the SEC rate bonds.
2) Use the prices of CDSs. Now I don’t think regulations can refer to the market prices of CDSs, which shoot up in a panic causing banks to have to liquidate assets justifying the panic. However, if Goldman Sachs were willing to issue CDS on 10% of the securities at a price typical of CDS on AAA corporate bonds, I’d be willing to buy them (Provided Goldman Sachs promised not to buy CDS on 20% etc).
The point is that as noted by MarshalN only a few big firms have the muscle to rate. We have learned it is unwise to trust raters who don’t put their money where their mouths are. Very few big firms have enough money to put where the major mouth investors respect from raters is.
This will not be cheap. If to issue a security that pension funds can buy, you have to find some entity willing to insure 10% of it (with guarantees that they don’t hedge that risk) then it will be very costly to issue a security.
That’s life. In the real world you don’t get something for nothing and rarely get something hugely valuable for almost nothing. For decades we got immensely valuable ratings from Moody’s, S&P and Fitch for almost nothing. Our luck has run out and it’s time to face reality as it almost always is.
Public ratings would be cheaper, but 2008 taught us as much about regulatory capture as they taught us about trusting private firms which don’t put their money where their mouth is. I’d say public ratings would work OK unless and until a Republican is elected President.
How is this different than buying equities? If you can’t do research yourself, hire a professional who can. If you can’t afford to hire a professional, then pool your resources with others and collectively you will be able to hire a professional — let’s call it a “mutual fund”.
I’ve always viewed most bondholders as impatient children, but this is a bit over the top. They demand government bailouts, priority in bankruptcy, less volatility *and* free, accurate research?
My firm does our own fixed income ratings, and we do not “sell” it. But one could hire us to manage their fixed income portfolio. There are many options out there aside from the rating agencies. Also I try to keep to my general rule – do not buy anything that you do not understand.
i don’t know why you would use CDS prices rather than the price of the instrument itself. they are the same data from a credit analytics point of view. one would be more liquid than the other but not necessarily the same one for every instrument.
ratings agencies did a terrible job with structured credit but have iirc done a decent job with corporate and sovereign and municipal debt, no?
none of this is why i am writing this comment, so i will write another comment with my real comment.
a week or two ago brad delong had a nice post about the purpose of the financial system and so on. one point that never seems to come up is that an eventual outcome of loan securitization — if the project as a whole had succeeded which it didn’t — was going to be a highly efficient and robust process for capital allocation. by that i mean that there would have been societal benefit in that the overhead and profit margin would have gone down considerably.
i say ‘was going to’ because financial institutions were temporarily receiving high fees but competition was going to bring them down — imagine how fees and margins would have dropped if loan volume hadn’t gone up like it did in 2005-7 but if ML etc had joined up.
this is different from banks making money on their trading books or making money on yield curve steepness. this is more that, well, if there is a way to consolidate and streamline the function of disseminating information about underlying loans and/or as was intended to make instruments that are robust wrt the underlyings — the investment process can be much more efficient.
so why not concentrate not on ratings agencies (delete them from legislation and leverage limits, and few will care whether they exist or not) but on standardizing disclosure, reporting, and information gathering?
The difference is that a firm with a lot of analytic muscle and skin in the game (eg Goldman Sachs) writes a lot of CDS so they have reason to check. The point is that a known big player with resources to do research is known to be long the security. The problem is blocking them from secretly hedging their position.
I did not propose just having a CDS market and using the market price. The key signal is that a well informed player is massively long at a price of their choice.
So what’s the alternative to the random series of letters they apply to bonds? I see two possibilities.
Since this is a lie it makes no sense to consider this guy’s recommendations seriously. The ratings agencies do a good job generally and its only a fool that gets a forecast in one year and expects its to pan out 2-3 years in the future.
Speaking of public forecasts we have Christine Romer prediction unemployment remaining below 8 percent if we approved a multi-billion dollar stimulus bill. The bill was approved but then unemployment went above 10 percent. She had an incentive to provide a cooked forecast to justify the bill.
The basic fallacy is the idea that the public sector acts independently and fairly. This is nonesense since they are at the whim of politicians and the political process.
Cardiff,
You left out an important additionoal point. “This is non[e]sense since they are at the whim of politicians and the political process.” This is logically inconsistent since the opublioc sector are the politicians and the political process. The whim, more accurately the interests, they serve is that of the private business sector. Lately that service has been focused on the interests of the financial sector of the private sector.
Few here at AB claim that politicians and their “advisors” are independent thinkers with the good of society in their hearts. Arguing against that position is the strawman approach to the issue. They do, and have for most of history, represented the interests of the business class otherwise also described as the wealthy elite.
I would add that leveraging with debt realted instruments and derivatives was/is the main issue – basically naked CDS writing, or buying the stuff with borrowed money. In teh latter cases it does not take a big price drop to ruin the issuer or purchaser. In my brokerage there are pretty strict limits on naked option writing, and margin purchases. Levergae limits is where the regualtion messed up. This all becomes disaterous when the price of these things become tough to determine.
Many organizations –retirement funds for example — are restricted by law or charter to assets with certain ratings. Worked not too badly until we let the inmates run the aslyum for a while.
Can you think of any reason that companies that purport to rate credit risk should not be accountable for their work? They are paid to do a job. If they can’t do that job properly, perhaps they should shut down, pay off their creditors, and distribute any remaining assets to their shareholders.
Jack,
I don’t think rating agencies got some of the complicated derivative securities wrong. However, I think they are more competent than anyone else but the result was obvously not satisfactory. So what I expect them to do is to review their analysis for weak spots, make what adjustments they think they need to make, and then implement it and stay in the game.
Few here at AB claim that politicians and their “advisors” are independent thinkers with the good of society in their hearts.
I’m here so don’t really need a primer on what other people claim. What bugs me about some of the writers here is that they make statements that show problems and then leave the reader to come up with the implicit solution of having the government become more involved in a solution to the problem. Robert and Mike Kimel do this them most in my view.
I think the majority of don’t want this every expanding government involvement. Future elections will show one way or another.
I heard that a lot of people think CDS is the problem. I always thought in my simple minded way I could just buy a bond fund, look at the average agency rating and duration for the fund and then see what interest I’m being paid for the sum of all the types of credit risk there are.
If it matters to me if someone else has sold/bought/hedged/frauded insurance on them, then I get confused in a hurry.
If that matters to the ratings agency, as it seemed to with CDO/CDS all the way up to ABACUS, seems FIRE made the job too difficult.
I think simplification is a great way to fix problems and think we should disappear CDS althogether.
As mcwop pointed out, the agencies did ok with garden variety MBS and Treasuries, but were bamboozeled by the “house prices can’t go down” story that was in vogue for a while.
I think the problem with sovereign debt they have now had a lot to do with CDS on sovereign debt.
Then there is muni ratings. Those are insured by muni insurers, but we found out they are undercapitalized. But at least there was a way to find out, and that is a different sort of regulatory problem.
I haven’t seen much in the news about how they did with corporate bonds, so I guess it’s going ok, except I would be suspicious of GM bond ratings. But stockholders had a problem there too.
But how to pay the rating agencies is still problematic. Maybe a buyer side fee somehow might be better.
I heard that a lot of people think CDS is the problem. I always thought in my simple minded way I could just buy a bond fund, look at the average agency rating and duration for the fund and then see what interest I’m being paid for the sum of all the types of credit risk there are.
If it matters to me if someone else has sold/bought/hedged/frauded insurance on them, then I get confused in a hurry.
If that matters to the ratings agency, as it seemed to with CDO/CDS all the way up to ABACUS, seems FIRE made the job too difficult.
I think simplification is a great way to fix problems and think we should disappear CDS althogether.
As mcwop pointed out, the agencies did ok with garden variety MBS and Treasuries, but were bamboozeled by the “house prices can’t go down” story that was in vogue for a while.
I think the problem with sovereign debt they have now had a lot to do with CDS on sovereign debt.
Then there is muni ratings. Those are insured by muni insurers, but we found out they are undercapitalized. But at least there was a way to find out, and that is a different sort of regulatory problem.
I haven’t seen much in the news about how they did with corporate bonds, so I guess it’s going ok, except I would be suspicious of GM bond ratings. But stockholders had a problem there too.
But how to pay the rating agencies is still problematic. Maybe a buyer side fee somehow might be better.
I heard that a lot of people think CDS is the problem. I always thought in my simple minded way I could just buy a bond fund, look at the average agency rating and duration for the fund and then see what interest I’m being paid for the sum of all the types of credit risk there are.
If it matters to me if someone else has sold/bought/hedged/frauded insurance on them, then I get confused in a hurry.
If that matters to the ratings agency, as it seemed to with CDO/CDS all the way up to ABACUS, seems FIRE made the job too difficult.
I think simplification is a great way to fix problems and think we should disappear CDS althogether.
As mcwop pointed out, the agencies did ok with garden variety MBS and Treasuries, but were bamboozeled by the “house prices can’t go down” story that was in vogue for a while.
I think the problem with sovereign debt they have now had a lot to do with CDS on sovereign debt.
Then there is muni ratings. Those are insured by muni insurers, but we found out they are undercapitalized. But at least there was a way to find out, and that is a different sort of regulatory problem.
I haven’t seen much in the news about how they did with corporate bonds, so I guess it’s going ok, except I would be suspicious of GM bond ratings. But stockholders had a problem there too.
But how to pay the rating agencies is still problematic. Maybe a buyer side fee somehow might be better.
VtCodger: “until we let the inmates run the aslyum for a while.”
For a while? Aren’t they still in charge?
Cardiff,
Government is the process by which an organized society coordinates and structures its activities, both social and commercial. The bigger that society grows so too will its government have to grow to be able to carry out its responsibilities to its citizens. One of those responsibilites is the system of laws which define how we interact with one another in all walks of life. Commercial activities require as much, if not more, structure and guidelines than do the social interactions that occur within an organized political society. That’s what a nation state is, an organized political construct. Ours is one of great size and therefore great complexity which requires an expansive government.
Where do we draw the line regarding the size of government? There is a wide span between anarchy and totalitarian control. Who’s to say the best point within that continuum? The commercial sector of our society has certainly shown us repeatedly that it requires vigilant over sight to weed out those that would abuse the rest of us.
And I haven’t really noticed either Kimel or Waldman to be unreasonable in their comment
replys to some of the off the wall comments that show up on this site. Try EconoSpeak. No ill tempered comments there. I can’t explain why that is. Maybe it’s more tightly monitored.
***ratings agencies did a terrible job with structured credit but have iirc done a decent job with corporate and sovereign and municipal debt, no?***
Well, CALPERS is suing the credit agencies for applying different (stricter) criteria to municipal debt than corporate debt. CALPERS is also suing them for wildly inaccurate ratings on structured investments. (And, in passing, the exact content of the structured investments allegedly was “proprietary” and was not made available to potential buyers) It’s a little hard to tell if CALPERS has additional suits in the courts as there are thousands of google hits on CALPERS lawsuits against the rating agencies and most pertain to the structured investment thing.
Oh yes, and the rating agencies are also apparently being sued by their shareholders. See http://seekingalpha.com/article/148934-calpers-sues-rating-agencies-for-bad-investment-advice
My guess would be that the rating agencies will likely run out of money long before they run out of outraged “clients”. Anyone reckon they had malpractice insurance?
Can you think of any reason that companies that purport to rate credit risk should not be accountable for their work? They are paid to do a job.
Except the people who are paying them are the issuers. And they offer an opinion on credit risk. And credit risk does not equal price risk. And price risk leads to real fundamental capital risk for purchasers of credit.
m.jed:
Is there still such a thing as ethical and moral behavior in what you represent to others?
AIG was rated AAA until Hank Greenberg was caught cooking the books and it went down to double A. There was a problem with the ratings of bonds issued by financial firms.
This was very very important as for laws and charters any instrument an entity owned was rated at least as high as AIG if the entity also owned a CDS on it written by AIG. This was the point of the whole scam which AIG-FP frankly called regulatory arbitrage. At AIG-FP they sincerely thought the regulations were pointless and finding a way around them implied profit without risk.
The problem with corporate bond ratings is related only to financial firms. The ratings agencies considered assets to be potentially risky but considered liabilities to be safe. CDSs written appear on the balance sheet at market price not at how much the writer might have to pay.
Lehman, Bear Sterns etc also had high rated bonds. oops. This is key as the rating on the bonds counts as the rating for all liabilities even though all liabilities are not considered when rating the bonds. double ooops.
Forecasts of unemployment are known to have wide confidence intervals. AAA ratings were assumed to imply extremely low probabilities of default. Romer did not say she was 99.9% sure that the unemployment rate would stay under 10%.
Also her forecasts were and are similar to those of private forecasters. I know of no evidence whatsoever that she cooked any books. Such an accusation must be based on evidence that her forecasts were significantly different from the average of those made by people who didn’t have an incentive to do that. You present no such evidence.
You also fail to note that following the stimulus there was a very sharp increase in the rate of growth of GDP from -6%/year to +5.8%/year 3 quarters later. This is a huge acceleration of GDP greater than any seen since Carter was President (and second greates in my lifetime).
The forecast of unemployment below 8% was made before the last pre-stimulus data were available. A forecast made with the same methods at the time of the stimulus would give a prediction of output without a stimulus much lower than actual output.
Can you name anyone whose job is to make accurate forecasts (and has a larg number of paying clients) rather than to advance the Republican party line who claims that the stimulus did not cause markedly higher GDP and markedly lower unemployment ? There are a whole lot of professional forecasters and, as far as I know, they all agree.
Well Jack I think you might notice it soon, because I’m going to ask Cardiff if he actually read the post. I was proposing a change in regulations not the introduction of new regulations. Current regulations refer to the ratings given by the big 3 rating agencies (it’s in the law). I was proposing replacing them with Goldman Sachs and, effectively, paying Goldman Sachs a ton of money to assess the risk of financial instruments.
My comment on a public rating agency explicitly noted that the ratings will be distorted by politicians. I claim that public regulatory agencies work well when a Democrat is President and work poorly when a Republican is President. I have no doubt that you find this claim offensive. However, I note that you offered no evidence at all which contradicts it.
If political interference with regulators is a universal problem, it should be easy to come up with examples of such interference by Democratic Presidents. I note that you have presented no such examples and, in fact, and, as usual, no relevant evidence at all.
run:
I think the term “long-term greedy” is what I’d respond to your question. The rating agencies have discredited themselves putting their entire business model at risk. Felix Salmon’s point is correct. But as elsewhere noted, there are typically GOVT requirements for ownership of a certain rating – for insurance companies, banks, gov’t pension funds, etc. This isn’t true of pension funds in equities, i.e., to my knowledge, no one mandates “blue chip equities”. There may be internally or consultant determined asset allocation, but not mandated by law.
Please explain the ethical/moral divide between opining on credit risk (the timely return of principal and interest) but having the credit subject to price risk (mark-to-market)
Amplification of a key point.
I would rather have a slightly sharper downturn that forces economic readjustment leading to years of economic growth then introduce mitigation that leads years of tepid growth in the economy.
Robert,
-6% to +5.8 was because the economy overeacted on the downside and then simply bounced back gaining back most of what it had temporarily lost. This is typical for recession, at least ones where they don’t raise taxes like the Idiot Hoover did.
I don’t see the evidence that infrastructure projects are leading the recovery. I don’t know of anyone employed previously as an analyst, lawyer, accountant, or grocery store clerk that lost their job, answered an add in the newpaper, and are now driving a truck, operating a crane, or doing general labor on an infrastucture project.
On forecasts you’re contradicting yourself. On the one hand you defend Romer because she was wrong together with other people that were wrong. But then you turn around and condemn the rating agencies even though their forecasts were consistent with the majority of outside forecasters. Your argument is thus shown to be skewed in favor of making an argument for bigger government involvment in the private economy. I’m correct to critisize Romer because she got in front of the American people, most of who don’t understand 95 confidence intervals on forecasts, and prestented a graph with what unemployment would be with and without the stimulus. So the Average person would conclude that if we support the stimulus unemployment would cap itself at 8 percent and be significantly lower today than it actual is. She blew her forecast. So again, this leaves you scrampling to rationalize her error and at the same time while you condemn the rating agencies.
As you take a look around in your Neighborhood over there in old Europe you might notice that the welfare state is threatening the very existence of the European Union. The Germans are being played as suckers to bail out and pay for the exorbitant benefits to an not very productive Greek economy. In America we would cut them loose.
One of the great positive attributes of the U.S. economy is its speed of adjustment. We have a history in certain industries and markets and in ther general economy of taking sharp downturns but then followed by very rapid recoveries followed by periods of growth. Obama is offerning to change all this by offering a new social contract where in exchange for political power he promises to mitigate the downturns. I don’t think he can do this and what’s happening in the EU is not a confidence builder. So my side argues to lower government regulation, taxation, and then allow the economy to adjust. With Obama’s way I don’t see the path to future sustained prosperity.
Robert,
You’re clearly demonizing the rating agencies.
And Cardiff is??
As someone who sells very expensive products to individual and their businesses I have frequent occasion to arrange financing of said products. I’m not talking huge money, but often the amount financed is in the area of $100K to $200K. The business apps. often ask if I want their Dun and Brad. ID. I ask the credit analyst if that would be useful. The credit analysts consistently hold that the D&B is nothing more than information provided by the applicant and may bear little relationship to their real credit worthiness. All they want to know is debt to income ratio and evidence of an inclination to repay a debt. Ratings are not likely to give such info in a reliable fashion. As Buffet has often said, just look at the fundamentals. The investors problem today is getting any information that remotely resembles a corporations “fundamentals.” And the ratings agencies apparently don’t provide that.
On thing I’ve been wondering about and haven’t seen any news about is how did they ever sell the so called “equity traunche” of CDOs?
There has been lots of talk about how CDOs are butchered up to have a AAA rated traunch that is buffered by lots of loss taking traunches below it, and finally at the bottom is the “equity traunch” and that’s how the NINJA cow goes to market.
But how did they sell the leftover unmentionables?