“There Were Ratings That We Saw That Made No Sense To Us.”

This American Life had another good financial crisis episode by the Planet Money team this past weekend. There’s a story on regulatory holes by Chana Joffe-Walt and one on rating agencies by Alex Blumberg and David Kestenbaum. The latter had some money quotes (starting around the 40-minute mark).

Jim Finkel, Dynamic Credit, which creates structured products: “There were ratings that we saw that made no sense to us. We knew the rating agency models and metrics, and we could replicate them ourselves, and we couldn’t make sense of what they were doing.”

Felicia Grumet (sp?), Bear Stearns, who was involved in creating structured products: “It makes me feel really bad, so actually it’s very hard for me to acknowledge . . . I knew what I was doing. I knew I was doing things to get around the rules. I wasn’t proud of it, but I did it anyway.”

One of the heroes is Mabel Yu, a buy-side bond analyst at Vanguard, who couldn’t get the rating agencies to explain the ratings they were giving to structured products – and therefore refused to recommend them internally at Vanguard. Who knew? Not only do you get lower costs at Vanguard, but better fund management, too? (I have most of my money at Vanguard, but it’s in all in index funds or near-index funds, so I guess I wasn’t benefiting from Yu’s research.) 

By James Kwak

11 responses to ““There Were Ratings That We Saw That Made No Sense To Us.”

  1. Rating agencies and regulation are only parts of the puzzle I think. What about litigation (note article below)? The financial industry has secured immunity from litigation (no ‘aiding and abetting’ in securities fraud, rigged arbitration in FINRA rather than court…and on it goes) and this allows ‘fraud without legal responsibility’. Every false rating by a ratings agency, every defrauded investor is a victim whose ‘right to property’ has been violated…and via Congress has no legal recourse. Certainly litigation can also be burdensome and protecting the free flow of capital is important…but where is the balancing point? Does the recent subprime meltdown suggest as a society we have erred on the side prohibiting litigation? Why does the Bear Stearns guy above have no fear of litigation after helping to destroy hard earned capital of investors?

    Rafel La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, What Works in Securities Law, The Journal of Finance Vol. 61 (2006).(Authors examine 49 countries and “find little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets.”).

  2. Throw them all in jail! I doubt Felicia Grumet was the only one on Wall Street who knew she was “doing things to get around the rules” but did them anyway. Used to be, when one broke rules, there were consequences….

  3. Good stuff Brad. Thanks for the article you referenced. When I think of banks and rating agencies, why does the saying “thicker than thieves” come to mind?? And Brad you used the R word!!! You dared to use the R word!!! REGULATION!!!! Shame on you Brad!! Brad, you can only use this word in hushed tones, like you’re in the university library the day before final exams. Or in a very disgusted tone, as if you’re talking of some extremely perverse crime. We can’t upset bankers!! I mean, really, if you were a banker and missed your golf tee time because you had to go bully a U.S. Senator to vote against his own constituents interests, how would you feel?? When bankers hear the R word, they tend to cringe as if someone is reaming them in a very fierce manner.

  4. Benedict@Large

    Congress only prohibited regulation; not litigation. Up to this point, the ratings companies have fended off litigation by claiming their ratings are merely “free speech”. To this point, that argument has prevailed.

    In this particular case however, I think that argument is nonsense because these particular ratings were not what these companies were in business to provide. In effect, these were not ratings of securities (what they were paid to provide and what they allowed investors to believe they were providing), but rather ratings of a methodology (which is all that can be provided without experience data). In effect, this “free speech” was an outright and deliberate (and very profitable) lie, and they must be held accountable for that.

    In this sense, “The Watchmen” missed the boat entirely. What they did a good job at was stating the current position of the ratings companies, but this thing is going to get a hell of a lot dirtier before it is done. The big three know well that they are facing bankruptcy here (and they deserve it), and a strong case can even be made for criminal charges (ERISA fraud) reaching right into their boardrooms (and they deserve that too).

  5. Credit Rating agencies were equally at blame. If you had read through “The Economics of Structured Finance,” by Joshua Coval, Jakub Jurek, and Erik Stafford (mentioned here sometime back), you would know that the underlying principle of calculation used by the credit rating agencies was flawed. The real risk of an instrument was never really captured. Although, looking at the bigger picture, I would rather say that this wasn’t EXCLUSIVELY due to these agencies, but they were ALSO responsible. Much of a case of ‘Not only, but also’.

  6. People like Yu deserve more credit.

  7. Response to Benedict@Large and additional comment.

    1-Benedict@Large is wrong (nothing personal). I practice law (also teach Finance at university) and I can assure you that the law have been past to limit liability for the financial system as opposed to typical commercial transactions. IF you do the legal research, you find limitations of litigation if it involves securities.

    2-Realize that the benefits bestowed by legislatures that favor securities/financial institutions are a form of intervention into the free markets. They are a form of regulation…but regulation biased towards the financial industry. So to restate the proposition…Wall St. is not against regulation….Wall St. is against regulation does not directly benefit them!

    If you look at the concept of ‘agency capture’ in both economics/finance and law….I found more references to the concept in law rather than economics/finance.

  8. bungalowbill

    I’ve just finished listening to the radio program. They basically point the finger at 3 entities:

    1) The Office of Thrift Supervision (OTS).
    Bizarrely, while they look like a federal agency, they are paid by the companies they are supposed to watch.

    2) Congress.
    They passed the Commodity Futures Modernization Act (2000)that prohibits the regulation of derivative products by federal agencies.

    3) Credit rating agencies.
    They are of course paid by the banks selling the mortgage-based products.

    I would remark that even if the OTS were funded by the taxpayer, they probably wouldn’t do a better job. As far as I know, the SEC is not paid by the financial industry. Still, they are very friendly with them. Many people working at the SEC end up getting a more lucrative job at some bank they were supposed to watch. I call that “tacit corruption”.

  9. not to mention the fact that you basically had to accept the prevailing models to have a job in this field.

  10. Vanguard says “Thanks James Kwak”!

  11. Just caught the program. Those Planet Money guys generally do a good job translating these issues into digestible bits for the wider public. There’s plenty of blame to spread around. The ratings issue sort of hit the back burner for a while, so I think swinging a small spotlight on the industry is a nice reminder. Ratings were basically laughed at on trading desks since spreads were so disconnected from ratings as the crisis unfolded. I talk about it a little in a follow-up video: http://notestoself.posterous.com/yacp-episode-2