We've joined the cacophonous critical chorus on the failure of the ratings agencies to anticipate the risks involved in structured credit products and the much mocked reform proposals. But conversations we had over the weekend have us wondering whether this scandal might have become overwrought.
At the heart of the scandal is the idea that the errors of ratings agencies damaged the market by convincing investors of the safety of credit products that have turned out to be far more risky than the ratings issued for them seemed to imply. This idea of harm on the market assumes that the products did not originally trade at a discount for ratings agency error. Should we really assume the market did not price in a discount for error? Was the market really priced for ratings agency perfection? What's the evidence for this contention?
Prior to the meltdown in the CDO market, there were many who warned that the markets contained hidden dangers. Are we to believe that there was no discount priced into even highly rated CDOs for risks so publicly discussed? The proposal from MBIA that ratings for credit products come with warning labels implies that such ratings should be priced with a higher discount for error than other types of credit. But since when do our institutional investors and much vaunted efficient market need warning labels to tell it that complex and little understood investments may be riskier than simpler credits? Wasn't there an implied warning label in the very nature of many CDOs?
The fact that CDOs may now be trading lower than they did in the past is not evidence of the absence of a discount, of course. As risks become more apparent, the discount for those risks often becomes heavier. This is a risk pricing issue but it doesn't imply that those who bought under the earlier discount were misled.
This question of a discount for agency error matters. Last week we learned that New York Attorney General Andrew Cuomo was investigating the ratings agencies, and possibly considering using the dreaded Martin Act to allege fraud. The Martin Act is a powerful tool for the attorney general because it does away with many of the evidential requirements to prove fraud in the securities markets. But, from our reading, it does require the attorney general to show that the conduct of the accused caused harm to investors. A discount for rating agency error might create a powerful defense for the agencies.
It might be time to take a deep breath. It's starting to look like the ratings agencies are in danger of being scape-goated for the indulgences of the credit markets over the past few years.
Posted by , Feb 11, 2008 9:10AM
*DJ Dow Jones To Change Composition Of DJIA >BAC MO CVX HON
Posted by Loyal DB Reader , Feb 11, 2008 9:12AM
Carney, you're about as entertaining as a quant. We're not here for a lecture, we're here for gossip, we're here for Bess, WE'RE HERE FOR CRAB HANDS
Posted by , Feb 11, 2008 9:14AM
c'mon there has to be some legitimate commentary otherwise i cannot justify spending as much time reading this blog as i do
Posted by anon4life , Feb 11, 2008 9:16AM
I thought this was one of the best posts I've seen in DealBreaker in a long time. Keep up the great work.
Posted by AJ , Feb 11, 2008 9:17AM
Ratings agencies are always scape-goats because investors won't ever take responsibility for not understanding what the hell they bought. And I don't understand why someone would trust the ratings agencies when they're probably the worst paid people in finance (don't even get me started though on the idiotic idea to have the buyers pay for ratings).
One final anecdote: In May we recapped one of our companies. Took out ~5x our original investment. Doubled the debt on the company. And got upgraded. All because we put on one hell of a pretty song and dance for the agencies.
Posted by The Mayor of Gotham City , Feb 11, 2008 9:19AM
Juan Carney,
Will you look into getting a Bess-Signal, kind of like the one we have for Batman?
Thanks in Advance.
Posted by , Feb 11, 2008 9:23AM
I suppose it might have been worth reading this post if it tended to suggest that the author possessed even a small hint of knowledge of law, finance or markets. But, as it is utterly bereft of hints in this direction we will never know, or be able to reclaim the time spent reading it.
Posted by Anal_yst , Feb 11, 2008 9:25AM
No Tobias news???? Get Levin outa bed and on it (the news, i mean)
Posted by anon , Feb 11, 2008 9:55AM
I love the comments about how Carney et al don't know anything about finance and that the time spent reading the post was a massive burden....And yet this person still spends the time to write out a completely pointless comment.
Posted by hps , Feb 11, 2008 9:55AM
a) The agencies weren't just slightly wrong, they were catastrophically wrong
b) Various regulators tell certain investors "it's ok to play with these guns if the rating agencies say so". Unclear how many actual kids were killed by these guns, but the agencies can't spin away this responsibility.
Posted by Banking Without Nets , Feb 11, 2008 9:57AM
@9:23
Carney called backdating exactly right when many folks lost their minds over it last year. He's one of the only writers who understands proxy access and executive compensation. The law professor bloggers like Ribstein, Bainbridge and the "Point of Law" crew treat him as a respect commentator. He worked in lev fin for Skadden and Latham for years.
You just sound like ass ranting like that. Carney puts his arguments right out there. Where's the evidence you know your ass from your other orifices?
Posted by fitchme , Feb 11, 2008 9:57AM
Carney, classical blame the victim posture.
Carney, did you ever write about the dangers of CDOs before January 2007? I'm not even sure you knew what they were then.
A warning label for a rating is a joke, implied or not. Many institutional investors have rules of a minimum rating before they can look at something. If the rating was bogus, it's the fault of the raters and the issuers. In fact, don't be surprised that criminal charges are to follow. Remember, some have to pay for their crimes before the ultimate bailout comes down. It's politics.
Posted by , Feb 11, 2008 10:19AM
Prior to January 2007? Your test is a bit early fitchme. That's asking Carney to have called the meltdown in CDOs at least 4-6 months early, which would have been a money losing call at the time. Didn't Carney get started here in May or June 2006? So you're giving him six months to have made th call?
Posted by Anon , Feb 11, 2008 10:25AM
I think he's reaching a bit with the last point. If the AG's office tries this in front of a jury, and the agencies best defense is "no harm - the market priced in negligence/recklessness/fraud," then they are in a lot of trouble. If the AG can make a convincing case that the agencies acted recklessly or fraudulently (whatever standard is under Martin Act), I think that is all a jury would need to hear. The AG would just need some plausible expert to say that the market did not efficiently price the recklessness/fraud in. I'm sure they could get that.
Posted by , Feb 11, 2008 10:28AM
Let's review-
Ratings should be ignored as a contributing factor because the market already gives them little weight. (Here JC, master of leveraged finance and "respected commentator" because some blogger once said something sweet about him, invents the "error discount.") So what if the reaction of markets demonstrates that they have a significant impact on price? We will ignore that, otherwise JC doesn't have anything trendy-contrarian to post.
Now what? "The Martin act is a powerful tool..." ?
Spare us. This isn't "A very special edition of 48 Hours."
I don't care where an author comes from. Posting shit is still shit no matter the bio.
Posted by 1-2 , Feb 11, 2008 10:31AM
Was there probably some fraud on these securities due to conflicts of interest? yes.
Did these guys screw up on a massive scale? yes.
Is this a reincarnation of every other "if you diversify enough then high yielding securities should give you a free lunch" "scandal? yes.
Does the fact that these agencies are in an awkward, quasi-governmental role of blessing securities based around market-distorting rules (ie, investment grade v junk and who can invest in each) probably play a huge part in the first three screw-ups? YES.
Posted by John Carney , Feb 11, 2008 10:33AM
Fitchme, I actually remember when I learned about CDOs. I was in law school, in a secured transactions class. And then in Regulation of Investment Management class we were assigned Frank Partnoy's FIASCO. So that would make it 1998 or 1999.
What did you know about CDOs in 1999?
Posted by s75 , Feb 11, 2008 10:34AM
respect to JC for putting this out there, since he spent most of last week savaging the same rating agencies, for a guy who allegedly does not possess "even a small hint of knowledge" to not necessarily succumb to confirmation bias
Posted by anon , Feb 11, 2008 10:36AM
10:28 - Yeah, no one pays any attention to ratings, which is why AAA super senior CDO tranches ended up on the balance sheet of the Wichita Fire Pension Fund (or wherever). I'm sure those guys modeled out the cashflows themselves because the knew how little weight the market assigned to ratings.
Posted by wtfmf? , Feb 11, 2008 10:42AM
I still fail to understand how such imbeciles end up in charge of huge portfolios where they can invest in exotic securities. I mean, honestly, you'd think anyone with a college degree has a reasonable shot at managing a pension fund somewhere.
Posted by Anon , Feb 11, 2008 10:50AM
From Amazon:
"Book Description
FIASCO is the shocking story of one man's education in the jungles of Wall Street. As a young derivatives salesman at Morgan Stanley, Frank Partnoy learned to buy and sell billions of dollars worth of securities that were so complex many traders themselves didn't understand them. In his behind-the-scenes look at the trading floor and the offices of one of the world's top investment firms, Partnoy recounts the macho attitudes and fiercely competitive ploys of his office mates. And he takes us to the annual drunken skeet-shooting competition, FIASCO, where he and his colleagues sharpen the killer instincts they are encouraged to use against their competitiors, their clients, and each other.
FIASCO is the first book to take on the derivatves trading industry--the most highly charged and risky sector of the stock market. More importantly, it is a blistering indictment of the largely unregulated market in derivatives and serves as a warning to unwary investors about real fiascos, which have cost billions of dollars."
Yeah, this definitely seems to suport the view that the markets efficiently priced in agency-ratings. Besides the "billions of dollars" that derivatives markets have caused "unwary investors", there was really no harm.
Posted by Witchita Fire Pension Fund Manager , Feb 11, 2008 10:52AM
Actually, we've sold off all of our CDOs to Citadel and Goldman and we're now net-short subprime.
Posted by , Feb 11, 2008 10:55AM
Face it, ratings are marketing tools, not risk management tools.
Posted by anon , Feb 11, 2008 11:00AM
10:52 - Brilliant
Posted by iheartbanking , Feb 11, 2008 11:06AM
why the focus on rating agencies and not underwriters who pay rating agencies, conduct due diligence, make way more money, etc.?
underwriters clearly have the most power of any of the parties involved in a given securitization, no?
Posted by , Feb 11, 2008 11:31AM
like any good criminal case you go after the low level guys (Moodys) hope they roll over on someone higher up the food chain (securities dealers)
Posted by , Feb 11, 2008 11:37AM
@10:52 @10:36 @10:42 Do you guys really believe the fireman in Wichita are having their nephew that went to Wichita State make these decisions, based on ratings from Moody's et al?
Reality is that its being done for them by PIMCO, WAMCO, Black Rock, GSAM. And those firms do their own analysis re credit quality.
Come on, what is this amateur hour here?
Posted by Ramblin' Wreck , Feb 11, 2008 11:38AM
Seems like the ratings are like drug dealers. They give you their word that the blow is quality stuff, and you're just supposed to take their word for it...at least, you do if you are addicted to said blow. I guess now that some of the clients have died because of bad product the rest of them will either stop using that dealer or at least take what they say with a grain of salt.
Posted by anon , Feb 11, 2008 11:44AM
11:37 - I'm sure part of the marketing pitch the big AUM shops gave the pension funds when deciding on allocations revolved around the "safeness" and "bulletproof" nature of the upper tranches of these structures. AAA was mentioned once or twice, probably.
Posted by , Feb 11, 2008 12:12PM
11:44 The audience for such pitches is much more sophisticated than you're imagining. If its the Wichita Firemen, you can bet they have a knowledgable consultant helping them. The investors are looking for returns versus a designated benchmark, not absolute safety of principal. And the asset manager achieves such returns through superior security selection, duration management, appropriate forays into extended sectors such as high yield and non-US. Maybe a few currency plays. Its not simply buy the highest quality securities you can find, based on the Moody's ratings.
Posted by Aspiring Mini-Baller , Feb 11, 2008 12:16PM
The ratings agency people are guilty of being incompetent pea brains. Calling them "criminals" is giving them more credit than they're due. I also agree that investors DO pay attention to the ratings (ie AAA) b/c large funds do have explicit guidelines that they can't buy stuff below a certain rating. Also, senior bankers spend a decent amount of effort vouching for a better rating on behalf of clients -- they wouldn't be doing so if the ratings were worthless.
Posted by Anon , Feb 11, 2008 12:17PM
11:37 - you are clearly a real pro (unlike the amateurs here). Surely every local fund is managed by Wall Street bigs. Like that state of Florida fund ($14BB) that hired Blackrock on December 4 - after seeing $867 MM default and spinning off $2BB of at risk funds into separate account. Before then, the fund was run by someone named Coleman Stipnanovich, who I guess is the "Larry Fink of the South."
Posted by , Feb 11, 2008 12:18PM
11:37, fucking nonsense, ton of muni plans redoing the OC fiasco. BB had an interview with a joker managing 3b+ in dallas for gov employees. they asked him if he was in cdo's, said yes. asked him what he knew about what he owned, answer was basically "nothing."
Posted by fitchme , Feb 11, 2008 12:23PM
OK, who's the "Wichita Firemen's" knowledgable consultant?
Reality is that when you get to figure who the consultants of these governments or pension funds are, you see some mediocre folks doing that job, and even some conflicts of interests. In those cases, there's no sympathy for those who got taken. But consultants, corrupt or not, may not have all the tools to figure out what's really AAA and what is junk on their own. Remember that for some of this stuff it had to be agency rated AAA before the salesmen even had the chance to get their foot in the door and be heard. The fact that there's idiocy in this environment doesn't mean the rating agencies didn't do anything wrong, or even criminal.
Carney, OK, so you have heard about CDOs before. That's great, but damn it, you didn't tell us when to short.
Posted by , Feb 11, 2008 12:35PM
@12:18 The funds you are talking about are cash funds, which are very easy to manage: with everything kept very short they can ignore the risks of spreads widening, yield curves moving, investments being downgraded, mortgage bonds prepaying, etc, etc. Problem though is that these funds allowed exotic vehicles to creep into the portfolio, in the form of SIV's, based on an overreliance on the AAA ratings of such securities. Don't confuse this mess with managing longer duration portfolios.
Posted by Aspiring Mini-Baller , Feb 11, 2008 12:40PM
Here is an example of the *top* consultants to the government / pension funds:
http://www.pfm.com/PFMAM/Professionals.htm
If you read their bios, you'll find a few qualified people and lots of ex-govt managers & state school grads -- not exactly rocket scientists providing the advice. I bet most of the consultants are much less knowledgeable than these guys.
Posted by , Feb 11, 2008 12:42PM
12:23 I agree with you regarding the board members of such funds, which are generally political apointees. The consultants though steer the board regarding investment decisions and take pains to be professional and independent (and are rewarded accordingly). Public funds represent a huge pool of money.
Posted by , Feb 11, 2008 12:52PM
This is starting to look more and more like the dot-com pricing technique scandal, where stocks were priced based on clicks or visitors because nobody knew how to value a website. The banks were selling securities tied to piles of crap but the agencies rated the securities based on the banks, not the crap. Is it their fault that their ratings model was not feasible for these securities or was it the fault of investors (most of whom were institutions and should at least have a basic understanding of the model) for not recognizing the shortcomings?
In other words, is it the investors' fault for investing in securities tied to piles of crap, banks' fault for making securities from piles of crap or ratings agencies' fault for overlooking the piles of crap in their rating? From the way this has played out, everyone has ignored the responsibilities of the banks and investors and said that it doesn't matter how irresponsibly the banks and investors acted, it was the agencies' fault for rating them the way they rate other securities when this was not the proper way to do it.
I can't wait for a fireman from Wichita to sue his pension fund for investing in a SIV backed by the mortgages of firemen from Wichita.
Posted by , Feb 11, 2008 1:11PM
yeah those idiot consultants always fucking up.
They need some Bear Stearns/Citi/BAC advisors to keep them out of trouble.
Posted by crabsofsteel , Feb 11, 2008 1:41PM
I've made Moodys an offer to buy their Binomial Expansion Technique model (aka "the mudel"), to put it up on eBay and see what it fetches. You know, that's the mudel they originally used to rate CDOs, and its initials are ... BET
Posted by fitchme , Feb 11, 2008 1:45PM
@1:11 PM
You missed Merrill Lynch. LOL!
Posted by , Feb 11, 2008 1:47PM
pls bear shouldnt even be mentioned in the same breath as CitI bac, ubs, merrill when it comes to racking up losses
Posted by Chris , Feb 11, 2008 4:29PM
Don't make fun of Coleman. He was part of a crew that made a killing in the FCOJ market in the 80s.
Posted by mp , Feb 11, 2008 8:34PM
Isn't Witchita Fire Pension Fund just a rebranding of Bear Stearns Asset Mgmt?