Long before we were told by the Securities and Exchange Commission that short-sellers and rumor mongers were behind our credit market crisis, blame was being heaped on the ratings agencies. While we’ve since moved on here in these United States, attention in Europe has largely remained focused on the ratings agencies. The Europeans are proposing that regulators take on oversight responsibility for the agencies, on the dubious assumption that regulators will better be able to determine errors in credit quality assessment than market processes.
But we have a better idea.
For those who believed that agency ratings were akin to Platonic forms–representing permanent metaphysical truths about the quality of a borrower or a credit product–the poor performance of highly rated credit instruments, especially those tied to the subprime mortgage market, comes as a shock. But there weren’t many of those subscribing to that faith who were trading debt in the market. We know this because prices on similarly rated credits based on very different asset types–say a triple A rated mortgage backed security and a triple A rated piece of general corporate indebtedness–weren’t identical.
Debt issued in riskier categories had lower prices and higher yields than less risky debt, regardless of the rating assigned. This demonstrates that players in this market understood that ratings were relative to the type of underlying debt.
Unfortunately, the divergence in pricing probably was not as great as it should have been. Those risky triple-A’s were even riskier than their pricing implied, which is one reason the losses on these instruments far outpace the models of the banks that bought and held them. There are strong indications, however, that these pricing errors were not market failures so much as regulatory failures.
Various regulations–from capital requirements at banks, to restrictions on pension funds investments, to disclosure requirements–created additional demand for highly rated debt built on risky assets. Take, for example, a state pension fund required to invest in only triple-A rated credits. It would naturally be tempted toward the riskier side of the credit market in order to achieve higher returns while operating within its regulatory restrictions. The problem was not that the fund managers didn’t understand the products were riskier–pricing made that obvious–but that they decided to engage in regulatory arbitrage, exploiting the gap between a regulator’s Platonic view of agency ratings and the reality of ratings.
Over time, such a dynamic becomes irresistible. With other pension fund managers, bank treasurers and corporate financial officers plumping their returns with risky credit products, a conservative investor who avoided this regulatory arbitrage would have found themselves underperforming the market, which is a quick path to unemployment.
The increased demand for risky-yet-highly-rated products would have depressed yields in the market, obscuring the information about risk from pricing. In short, a body of regulations that didn’t fit well with market processes wound up distorting those market processes in a disastrous way.
The European proposals to regulate the credit agencies seek to bring the ratings into line with the regulators’ preferred Platonic view rather than make the regulations better fit the market. In order to do so, the propose removing information from the market–or at least making it harder to come by. Rating all debt regardless of the assets beneath on the same scale will make it more difficult to make comparisons within asset classes.
What’s worse, there’s little to suggest that regulators will be able to more properly assess credit risk than the market processes–however flawed–that preceded them.
Fortunately, the very market processes that demonstrate that the regulatory view of agency ratings was mistaken also point to a market-based solution. Instead of relying on ratings for satisfying capital requirements, fund-rule compliance and disclosure, the regulations should be built off actual pricing of instruments in the markets. Here’s how a market-pricing regulatory scheme would work: the riskiness of instruments would simply be judged by their yields. Higher yield credit instruments would appear in the riskiest categories while lower yield instruments in the least risky categories. Rather than rely on the wisdom of experts–regulators or ratings agencies–the system would rely on the collective intelligence of markets.
No doubt such a system would be hated by many fund managers, financial officers and banks. They prefer the Basel II methods–which either rely upon their own internal expertise or rating agency expertise–for evaluating credit quality. Regulators too will be loathe to give their rules and rule-making powers. Even ratings agencies would probably resist, as it makes their ratings less important. And we know all to well that it is now fashionable to despise mark-to-market requirements, to which this proposal bears a strong resemblance. But with billions of write-downs and government bailouts, is it too much to ask that the markets be given a chance to better the experts?
Mayo
Can anyone tell me why Paulson os pushing “Covered Bonds”?
the socialist bankers in europe said it was a good idea.
CNBC referred to Hank as Investment Banker-in-Chief. funny
Or, just force a bond holder to mark a bond at: min(Rating, CDS implied)
Most institutions already have to mark a bond at the minimum rating, so this is just one more ‘effective’ rating. They could even do an N day moving average to ‘smooth out’ vol – which would give the CFAs and actuaries something to do.
Tell me is Hank not the lead Socialist banker in the United States now?
Carney I’m convinced you have way too much time on your hands (coming from me thats saying something)!
One thing I’m sure you’re aware of, but seem to miss pointing out here, is that the existence of the ratings agencies, and institutional investors’ reliance upon their ratings, is all part of the “CYA” mentality implicit in such investing programmes. If a pension manager can buy into a AAA CDO^2 yielding 100bps over a AAA leveraged loan (ceteris paribus) he’s flexing his fidicuary muscle and working for extra yield within the constraints imposed on him.
“Hell, S&P/Moody’s/etc said it was ok, its not my fault it turned out to be crap, I was just following the rules…” might go the inevitable explanation when things finally hit the sh!tter.
The reason there won’t be a market-based approach you’ve proposed is because 1)similar to the regulatory arb you’ve discussed, this approach leave plenty of room for manipulation/arbitrage, and 2)and partly because of #1, it leaves less CYA opportunity.
Mr. Carney,
Nice piece here. Interesting, well written, and meaty. Thanks..
check out sub section (b) of SEC. 3081 of the fannie bail out bill….
check out sub section (b) of SEC. 3081 of the fannie bail out bill….
Jc, really enjoyed this post.
I think we need to give pensions and 401k’s more selection, create greater competition for those investment dollars.
Maybe allow hedge funds to apply for portfolios, where they would have the same restrictions as the current pension funds. This would allow funds with good track records to expand their AUM, while giving consumers choices and making credit agencies (like the astute downgrade of freddie and fannie…on friday) largely obsolete(same as today).
Analyst,
I totally agree that the ratings were used as CYA. That’s partly why I’m advocating we not use them that way. Pricing above ratings.
One of the problems of following a rules based model rather than a principles based one. Of course it’s rather hard to get people to willingly engage with a principles based model in a tort environment like the US – Lerach et al. are bad enough with the box-tickery we use as is. Can you imagine what glee the plaintiff’s bar would approach a principles based system with?
Yet another reason why pensions are a bad idea – too much concentration of risk. Same for all of those funds that use model portfolios – you get diversification of headquarters and the clubs that money managers belong to, but no diversification of holdings. But you get to pay much higher fees than an index fund with a false sense of security! I feel better already!
As always, retail investors get screwed.
@ BB
Agree with all 3 of your points, without tort reform (ha!) that’ll never happen (and heaven help us all if it does!)
Model portfolios are a joke (mostly) to rape the retail class who is too busy/indifferent/etc to do their own investing. Interesting that in other specialities, say, medicine or even landscaping, people are at least getting something useful while getting fleeced (usually). Managed accounts and other rapacious schemes against retail investors seldom provide the same sort of benefits. But, as they say, you know, sheep, slaughtered, caveat emptor, yadda yadda yadda….
BB, lets not lay the blame only at the lawyers’ feet, the business side too exploits ‘principle-based’ accounting as it may please when times are good.
The only thing that is in favor of the business side is that given the freedom, firm taking on excessive risks will be penalized at some point of time. However, we all know how things play out when that time comes – the government is there to bail people out ‘to protect the system.’
Suffice to say, I am starting to lose my extreme faith in capitalism – thanks to big government socialism. One of the guiding principles of capitalism is greed, and the correcting measure is payback. However, like normal humans – the so-called capitalist chase greed and yet seek bailouts when the results start to pour in.
And your friendly neighborhood socialist government is always ready to bail you out. In the process, the true capitalist who took risks commensurate with rewards is the one who is penalized. The ultimate winner is the socialist. Not only does he get to penalize the TRUE capitalist, he also gets to use the example of the meant-to-fail capitalist to denounce capitalism as a whole.
Depressing.
@14 – principles vs rules based is just another agency problem. There are no solutions, just trade-offs, and I didn’t mean to imply that the evil commie tort lawyers were the only problem (though they are evil communists).
This is the problem with crony-capitalism and big-government conservatism. Capitalism gets the blame when its actually the socialism that causes the problem – too-much socialism and not enough capitalism, while the Schumer’s of the world claim to great effect that it was too much capitalism that did it. Or, as my preferred candidate said, Wall Street was villainous.
Being conservative too early in a bull market (in your portfolio, rather than ideologically, though one typically follows the other, except for a Mr. Buffet) gets you fired just as being short too early does. The market can be irrational longer than you can afford to be right. Only news-letter writers can be bears, but then they’re always bears and never have the discipline of ACTUALLY running money.
Unfortunately there are no easy solutions, but that won’t stop politicians from offering some. Thankfully HNW investors have options of working with some truly intelligent people who run on an absolute return model. Family Office firms and the smaller Swiss Banks offer some very nice products, and I’ve been especially impressed with some of the small shops where the principals’ money was tied up in the same portfolio as everyone else. It’s just that it takes a substantial net worth so that you can actually verbalize all of your inherent risks and positions as well as being willing to take moderate consistent gains instead of 30%+ and a blow-up.
“Or, as my preferred candidate said, Wall Street was villainous.”
Dont even go there! This election is the socialists’ ultimate revenge. They have a dyed in the wool communist they worship. And up against him is a pseudo-socialist, whom they adore as he has been an eyesore for the otherside (euphemistically tagged ‘maverick’).
Some great choices indeed.
Excellent post. As I enjoyed my toast with marmalade and cup of tea this morning, I spluttered as I heard about this proposal on the Today programme:
http://www.independent.co.uk/news/business/news/bank-set-for-fresh-battle-with-treasury-over-mortgage-bailout-plan-879501.html
For those short of time, the proposal in the UK is that our government stamp MBS “to indicate that a mortgage securitisation comprises only the finest quality of loans”.
Christ on a bike.
Being of a capitalist nature, I like the idea of using market data rather than backroom deal making to “rate” risk. It is more transparent and the emphasis on performance is finding paper that the market is pricing low and riding it up as the market realizes its mistake (which off course contradicts the idea that the market is instantly price efficient but that’s what managers get paid for) or at least until someone figures out a way to scam the system.
But I would like to point out that not every government intervention is “socialist”. Socialism is public ownership/control for the public benefit. When government intervenes in the market to benefit private interests it can be many things including crony capitalism or combined with certain political aspects – fascism. But not socialism.(And a corrupt government calling itself socialist doesn’t make it so.)
#18 said – “Socialism is public ownership/control for the public benefit.”
Agreed. But there are various ways of getting to it short of explicit nationalization. The current day liberals here have realized that outright exposition of socialism will result in a lot of backlash as people still recall the disaster that it results in.
Hence they resort to regulation, controls, permits etc to achieve the same goal. If the government sets the prices, the choices and the number of competitors (eg electricity, very soon ALL healthcare) then what is the difference between being government run and private?
As far as ‘crony capitalism’ and ‘fascism’ go, they are not different from socialism but the end result of socialism! The reason socialism invariably fails is because it automatically – by force of human nature – results in one of the above.
Yes, socialism can be implemented by means other than outright ownership.
Yes, I’m also a pessimist that government (and corporate) power will be abused.
No, fascism and communism and other anti-capitalism ism’s aren’t just failed versions of socialism. They are their own ideologies.
It is nonsensical to lump all versions of corrupt government as “failed socialism” (and implicitly ignore the “failed” qualifier) and this just provides a “red flag” that can be waved by crony capitalists to distract attention from their corruption.
And if distrust of capitalists and the belief in the need for some government intervention is “socialism”, I guess that makes Adam Smith the Father of Socialism.