Reforming Credit Rating Agencies

This guest post was contributed by Gary Witt, an assistant professor in statistics and finance at the Fox Business School at Temple University. He was previously an analyst and then a managing director at Moody’s Investors Service rating CDOs from September 2000 until September 2005. Witt also caught one error in 13 Bankers, which I explain here.

Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. So here’s my humble take on the current CRA reform proposals.

What should be the goal of rating agency reform?

In 2007, as S&P and Moody’s were trying to decide how to rerate the entire structured finance debt market, I asked a shrewd fund manager what advice he would give to the management of a rating agency. He said they have to get the ratings right. No matter how hard it is, they have to focus on getting the ratings right.

There is an alternative school of thought. Instead of improving ratings, the reform agenda should be to be to eliminate their use. Since the rating agencies are hopelessly stupid or corrupt or both, just say no. End the market’s addiction to credit ratings by eliminating the SEC designation Nationally Recognized Statistical Rating Organization (NRSRO). Go cold turkey and end the practice of using ratings to assess credit risk by governmental or regulatory entities.

These two competing goals, improve credit ratings and eliminate credit ratings, can be viewed from a larger perspective, a Minsky mindset. If stability breeds instability, then trust breeds disappointment; the greater the trust, the bigger the disappointment. The rating agencies were over-trusted until 2007.

But looking forward, as a bi-polar sufferer might do, isn’t the best strategy to try to manage this fundamental aspect of our identity by taking off the peaks and troughs of our swings in trust? In trading terms, if trust is the underlying commodity, we should manage our mood by selling an OTM call to fund a long OTM put and avoid capitulation here at the bottom of the trough in our trust.

The Financial Stability Act of 2010

How does the financial reform act being considered in the US Senate address the rating agency problem? Two significant amendments were passed on May 13, one from Senator Franken and one from Senators LeMieux and Cantwell. They are bolder (or perhaps more theatrical) than the previous provisions and almost perfectly reflect each of the two very different strategies: improve credit ratings and eliminate credit ratings. It’s not so clear if the amendments work well together or with the other CRA provisions of the current financial reform bill.

Prior to those amendments, the existing provisions in the bill sought to both improve and de-emphasize but not eliminate credit ratings. That’s a good, sober approach that reflects the philosophy outlined by Assistant Treasury Secretary Michael Barr (Financial Institutions) in his remarks before the Banking committee in August:

“Our legislative proposal directly addresses three primary problems in the role of credit rating agencies: lack of transparency, ratings shopping, and conflicts of interest. It also recognizes the problem of over reliance on credit ratings and calls for additional study on this matter as well as reducing the over reliance on ratings.”

The Franken amendment would attempt to improve ratings by addressing the conflict of interest issue. In Franken’s amendment, a Rating Advisory Board would be appointed by the SEC to assign one qualified NRSO to rate each securitization. The criteria for assignment could have a random component assuring that all qualified agencies get to rate some transactions but the Credit Rating Agency Board is directed to consider “the effectiveness of the methodologies used by the qualified nationally recognized statistical rating organization.” This seems to invite a contradiction of Secretary Barr’s admonition that “the government should not be in the business of regulating or evaluating the methodologies themselves.”

Here’s a good description of Franken’s amendment with some context.

The LeMieux/Cantwell amendment cuts right through the problem of over reliance on credit ratings and ends Secretary Barr’s time for additional study. It deletes all references to credit ratings from the Securities Exchange Act, the Investment Company Act of 1940 and the Federal Deposit Insurance Act. While not actually eliminating the NRSRO designation, Senator LeMieux describes his amendment as follows:

“My amendment writes these organizations out of law. . . . In a way, we’re looking here and saying the astrology that we relied upon in the past didn’t work. Let’s have some new and better astrology.”

I don’t fault the Senator for the astrology remark. Credit ratings are predictions about the future. My question is, “Where is this better astrology?” His amendment seeks to eliminate but not replace credit ratings in regulation. If you try to replace something with nothing, you create a vacuum. Ironically, one of the unintended consequences here could play right into the hands of S&P and Moody’s. If you undermine the significance of the NRSRO designation, you risk hurting the seven newly minted NRSROs more than the well-known brand names.

In addition to the two recent amendments, the original rating agency-related provisions of the bill are summarized here.

New Requirements and Oversight of Credit Rating Agencies

1) New Office, New Focus at SEC: Creates an Office of Credit Ratings at the SEC with its own compliance staff and the authority to fine agencies. The SEC is required to examine Nationally Recognized Statistical Ratings Organizations at least once a year and make key findings public.

2) Disclosure: Requires Nationally Recognized Statistical Ratings Organizations to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.

3) Independent Information: Requires agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible.

4) Conflicts of Interest: Prohibits compliance officers from working on ratings, methodologies, or sales.

5) Liability: Investors could bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.

6) Right to Deregister: Gives the SEC the authority to deregister an agency for providing bad ratings over time.

7) Education: Requires ratings analysts to pass qualifying exams and have continuing education.

8) Reduce Reliance on Ratings: Requires the GAO study and requires regulators to remove unnecessary references to NRSRO ratings in regulations.

Here’s how I rate these provisions.

(1) AA

This one should have been included in the CRA Reform Act of 2006 but better late than never. There are three big questions in my mind. a. What type of staff? Will it include some people with relevant experience either at rating agencies or at issuing or underwriting firms who have dealt with rating agencies?

b. Will the new focus at the SEC include the measurement of rating agency performance? The SEC needs to perform this critical task in-house, not wholly delegate it to the rating agencies themselves. Of course, this too has staffing implications.

c. How would fines be assessed? If properly targeted, fines could be a powerful tool to change incentives. For instance, the SEC could specify up front that financially painful fines will be levied for poor performance especially for an excess percentage of losses for ratings in the highest category.

(2) BB

Transparency is good except when it isn’t. Rating agencies have been sharply criticized for revealing their methodology and thus allowing investment banks to “game” it. You cannot have it both ways. If a CRA has a transparent methodology, issuers or structuring bankers will use that knowledge to get better ratings. On balance I think transparency is good but issuers and underwriters will express strong opinions about anything that adversely affects them so investors and the SEC staff (see (1) above) need to voice their opinions about rating agency methodologies as well.

Regarding disclosure of rating agency track record, CRA’s have always had staff publishing self-assessments. That’s fine but it’s very difficult to compare rating agency performance using their own idiosyncratic self-assessments. Surely the SEC needs to measure and publish comparative studies of rating agency performance (again see (1) above)

(3) CCC

Toothless. The information “considered” by the rater is irrelevant. It’s the weight assigned to each piece of information that is critical. This is probably meant to help the plaintiff’s bar in number (5) but I doubt it will.

(4) B

This is worth keeping in the bill but incredibly weak. Franken’s amendment is definitely more effective at addressing the conflict of interest.

(5) B

OK but again weak. To avoid “knowing and reckless failures” the agencies will catalogue every conceivable risk in committee memos and thought pieces. I doubt this will affect actual rating decisions.

(6) A

Good but basically a nuclear option. The threat of deregistration is important but fines would be more helpful in practice to create incentives for better rating performance.

(7) BBB

Worth doing.

(8) AA

Good provision. Follows the main recommendation from Assistant Treasury Secretary Barr to the Senate Banking Committee in his testimony from August. LeMieux/Cantwell is a bridge too far.

Improvements

Actually the bill may give the SEC all the power it needs but, how will the SEC use its new power? As Arturo Cifuentes said in his testimony about CRA reform before Senator Levin’s sub-committee on April 23,2010, the current CRA regulations are like a building code that prohibits tall buildings but does not define tall. I agree.

The SEC needs to do three things.

(a) Define rating standards [but not methodology].

(b) Measure and publish rating performance.

(c) Impose fines for poor performance.

By way of example, there could be five simple categories: A for securities expected to lose under 0.1%, B for expected losses between 0.1% and 1%, C for expected losses from 1% to 5%, D for expected losses from 5% to 10% and F for securities expected losses between 10% and 20%.

As you can see, I would do away with AAA. The notion that an essentially riskless category exists should not be encouraged.

The fines would be heavy only for large-scale losses of securities with an A rating. Again, as an example, levy big fines for losses on A rated securities in excess of 10% for a given category and vintage or in excess of 1% across all categories and several years.

The fines help address the conflict of interest in the rating agency business. Rating agencies need restoration of the balance between rating performance against short term profitability. In the past, rating analysts expressing concerns about inflated ratings were seen only as threats to profitability. Fines do not guarantee accurate ratings but at least future rating agency employees who express concerns about inflated ratings have a chance of being seen as loyal employees working to ensure future profitability.

66 responses to “Reforming Credit Rating Agencies

  1. The solution you favor will depend on what you think the problem was, and why you think it happened.

    In my view, the problem was: Ratings agencies gave AAA ratings to utter garbage. The reason was: They were well-compensated for doing so.

    So, I would start by forbidding ratings agencies from taking any compensation whatsoever, directly or indirectly, from the issuer of the rated instrument.

  2. I have a stupid question.

    Why can’t rating agencies operate just like Experian, Equifax & the like, getting paid by the *lenders* & *investors* rather than by borrowers & issuers of securities? That by itself would properly align their incentives. Why is it so difficult to come up with a payment mechanism like that?

  3. Michael Gjerde

    I have an idea, actually require the rating agencies to examine the componets of the thing they are rating. Actually requiring they get the full information of what is in a CDO before they rate it! Not just use models based on FICO scores. They didn’t do any work to earn their money. Just stamped OK on junk. The current agencies should be abolished as completely incompetent as proven over and over in their rating of Junk as AAA.

  4. The wide ranges of default rates for the letter ratings still seem to permit games to be played with structuring. Mathematically, at least, can’t I take a bunch of “C” bonds expected to have default rates smoothly distributed between 1 and 5% and make it into two tranches, one rated “A” and the other still rated “C”, except that my “C” tranche will have an expected default rate right at the edge of the permissible band, say 4.9%, which is much worse than the average of the original bonds?

  5. The problem is: one person or firm buys the rating, and then the info gets shared all over the Street. The rating firm then doesn’t make enough return to survive.

  6. I think I am more knowledgeable than the “average joe” on this stuff, but I have to say this one has me a little miffed also. I think it probably has something to do with the “free rider” problem, but I think if they wanted they could work around it.

    I think this is a good post by Mr. Witt, but I wonder if it isn’t mildly naive. What is to stop a Republican Congress and Republican President from cutting SEC funding and cutting SEC staff if they think the fines on rating agencies are being ladled out to generously??? In fact this is exactly what happened to Arthur Levitt when Phil Gramm was controlling the purse strings. Where would the fines then be allocated??? In the end it just gets right back to politics.

  7. I should have typed “too generously” above. I don’t know why that word always gets me.

  8. Ginger Yellow

    “The fines would be heavy only for large-scale losses of securities with an A rating. Again, as an example, levy big fines for losses on A rated securities in excess of 10% for a given category and vintage or in excess of 1% across all categories and several years.”

    The problem with the fines-for-inaccurate-ratings concept, as I see it, is that it will seriously discourage new entrants and smaller agencies – far more than a deregistration threat, which would I think provide a serious incentive for the big three to be more conservative if it were credible (a big if, admittedly). If the fine is sizeable enough to be an incentive for the big firms, the risk of assigning an A rating will almost always outweigh the benefit for small firms. For an issuer paid agency (like DBRS), this will make it basically impossible for them to compete. It’s slightly different for investor paid agencies, but again, over a large universe of (appropriately) A rated asset classes, some are going to experience serious losses in a massive economic crisis. It seems a bit perverse to fine the agencies for saying something would only default in an extreme scenario if it then defaults in an extreme scenario, and it would probably dissuade them from participating in asset classes which are generally safe but vulnerable to systemic risk. If you’re an investor who wants that sort of risk, you’re not going to engage that agency.

  9. Wouldn’t the risk of the fine just be worked into the fees the rating agencies charge?

    If you implemented fines for rating agency “performance,” I am not sure on some instruments how you would separate downgrades because something legitimately changed in the issuer’s credit profile from a purely bogus initial rating. Also, downgrades tend to exacerbate funding problems in some instruments. The problem there is not with the rating agency but with the structure of the security being rated.

    People need to accept that they outsource credit analysis at their own peril.

  10. I don’t think so. The minimum default rate on any C bond would be 1% or greater. It would be possible to create a C-A, C-B, and C-C subclass, but that would defeat the purpose of class simplification. The mathematical manipulations that appeared to allow tranching of CDOs was based on the faulty assumption that the securities involved moved independently. They don’t, so any probabilistic manipulation will ultimately fail.

  11. This sounds similar to the argument against higher liability caps for companies drilling offshore oil wells. Being that it would scare off smaller companies that can’t pay it. Like, “Wouldn’t it be horrible if companies that can’t clean up their own environmental disasters couldn’t drill??”

    In other words: Sounds like a load of crap.

  12. This is also an example of why applying A-B-C classifications to investments is probably not a good thing. It implies a further analysis of quality that is not really present. Far better to leave the rating numeric to some precision and let the investor determine for themselves what an “A” level of risk is. There would be so much subjectiveness in the rating system anyway that these simplifications should hold zero selection validity in the first place.

  13. Ginger,
    I might also add, fines could be set proportional to firm/agency size, could they not?? I mean based on your premise.

  14. This is a different feature from correlation. It works even when the securities are perfectly correlated. Suppose that the securities which are going to fail all fail on the same day. The rating system is inherently probabilistic, so I expect 3% of the securities to fail, for example, if they are evenly distributed from 1-5% risk. By structuring I essentially get to apply all those failures to my “C” tranche, which I constructed to have to have 60% of the value with a 5% expectation of failure. That leaves me with 40% of the value to sell off as more expensive “A”.

    I agree that the cure is to use numeric rather than categorical ratings.

  15. Or, as I thought you were alluding to in the opening paragraph(s), we could simply force buyers (namely Pensions, Endowments, and other Institutional clients) to Do The Own Due Diligence instead of using Ratings as a CYA to fall-back upon in the case the initial rating turns out to be too-rosy.

    What, then, to do for retail investors? We let them invest in the stock of companies the analysis of which is at least, if not more complicated than that of a straight senior secured (for example) bond without some Universal and All-Knowning blessing of suitability, why don’t we do the same for fixed income?

    Joe or Jane Investor have about as good a chance of understanding junior subordinated claims on a firm/entity’s cash flows as they do of understanding quantum physics (presuming neither are, actually, physicists)!

  16. I believe one of the primary risks of “putting the rating agencies under the microscope” – particularly at this time – will most inevitability result excessive fear among these rating agencies of NOT issuing negative credit actions, and perhaps also MAGNIFYING the perceived risks related to such actions.

    After all, from the credit rating agencies’ perspective, again under immense pressure and scrutiny from various government bodies, would rather issue “false positives” (negative credit event, unwarranted) than missing a materially negative credit event (ex-post, of course)!

    This, in turn, leads me to believe that the CFOs, Finance Ministers and other issuers of rated debt are likely going to go out of their way to prove innocence before guilt, seeking to re-assure markets (and the rating agencies’ now skeptical eye), and so on.

    This, I believe, will indeed raise many more eyes – namely those of investors’ who, recognizing this new, skeptical-inclined rating agency perception, will duly price in this additional “risk premium”, credit will become more expensive and a downward spiral in credit markets again take hold.

    Just a thought, but such a scenario is already unfolding (at least, the result). Check out TED spreads, LIBOR, etc.

    Human behavior is tricky. Politics, geopolitics, rationality, miss-aligned incentives, etc. etc. etc. can be dangerous.

  17. Kliment Voroshilov

    Reform this, reform that, is there a topic that appears on this blog that ever fails to presuppose the feasibility of reform? We’ve had our democracy stolen out from under us and Witt – or is it Witless – speaks as though the reform of credit agencies is something that one might reasonably expect? Headline: There will be no reform of credit agencies, no reform of finance, no reform of heathcare and no international peace as a matter of fact short of a “peoples’ moment” in which the pathologies of the present dispensation are exchanged for the justice of the next. I’ll believe we’re reforming credit agencies when I see the president of S&P in shackles, blubbering confessions, the object of a public trial in some emormous sports palace.

  18. This is absolutely the starting point. Deploying a provision in which ratings-seekers are randomly assigned to an agency and compensated from a fee pool is a start. Apportioning business by accuracy & price competition would be better over time.

    As to doing away with ratings, the question becomes how to regulate capital requirements in a financial environment that is rife with asymmetric rewards (not just TBTF, but everywhere – compensation, career success, etc.).

  19. Agreed with you/BlackBox. Same reason why High Schools that use a 0 (or 50-100) scale, absent some other factors like course-weighting, etc, offer far-more precise (ceteris paribus) representations of students’ academic performance than schools that use A/B/C or worse, Pass/Fail.

  20. “People need to accept that they outsource credit analysis at their own peril.”

    QED!

  21. Scot Griffin

    Should institutions that seek ratings from these agencies own or control significant investments in the ratings agencies? They do.

    Moody’s is 100% institutionally held. Morgan Stanley, for example, holds about 4% of Moody’s outstanding shares. Yes, some or all of those shares are held for the beneficial interests of MS customers, but Morgan Stanley is the “shareholder” that Moody’s actually talks to. Other institutional holders of Moody’s include Goldman Sachs, Wells Fargo, and Bank of America.

    http://www.nasdaq.com/asp/holdings.asp?symbol=MCO&selected=MCO&FormType=Institutional

    There are lots of ways to exert influence and control over a ratings agency. Channeling Bill Black, the best way to subvert a ratings agency may be to own one.

  22. I concur.

    Reform: outlook negative.

  23. Michael Rodgers

    I think a major problem credit rating agencies faced was that they didn’t have complete data. In dealing with CDO’s and CDS’ we are talking about contracts that were often locked in PDF’s. How does someone verify the data that would eventually be used in risk valuation systems?

    Jian Hu, writing in The Journal of Structured Finance, “Assessing CDO’s backed by Structured Finance Securities: Ratings Analysts Challenges and Resolutions” Fall 2007, reveals the challenge when he acknowledges that in the end, teams on analysts would review all legal contracts, including the CDS assigned to a tranche, and interview the company (45).

    Right. In 2006, there was over $520 Billion worth of CDO’s issued. I can only imagine the ‘teams’ who poured over these legal documents…

    Risk systems are only as good as the data in them.

  24. Michael Rodgers

    I think the real culprit is how the SEC and Bassel committee on Bank Supervision allowed financial firms to use their own interpretation of VaR numbers for measuring their risk exposure and setting aside capital reserves to offset that risk.

    In the end, I think this was a liquidity crisis brought on by poor management decision making with incomplete information during times of market bubbles, as witnessed by Lehman and AIG.

    There were plenty of warning signs that the subprime market was in trouble without credit rating agencies. These firms (Lehman and AIG) simply had a singular focus on revenue growth that blinded them.

  25. What the real problem was (and is) is the rating of derivative products and permitting their purchase by institutions managing other people’s money on the basis of these ratings. The agencies entire expertise is limited to analysis of individual companies. They have no useful methods for analyzing strucured products, and history suggests that no such methods exist. Prohibit the purchase of structured products by banks, insurance companies, mutual funds, municipalities, etc. Restore Glass Steagall, let the investment banks buy and sell this drek among themselves, and when one or more of them explodes, sayonara and good riddance!

  26. The Senate voted to advance the financial reform bill this afternoon. Up or down vote either late today or tomorrow. The deal has been made. The incumbents need a law and they know it.

  27. Levying a fine for inaccurate ratings is an interesting idea, but suffers from the same problem that led to banks taking too much risk. Payment for an inflating rating, and bonuses tied to that income, are immediate. Losses for an inaccurate rating are in the future, and probably will not affect the income of the person making the rating.

  28. The problem with credit ratings and credit rating agencies are twofold:

    First is their importance in setting the capital requirements for banks. That should be eliminated, not only because credit ratings could be wrong as we have seen, but mostly because regulators have no role arbitrarily intervening in how the market manages risk.

    Second we have a very serious asymmetry in credibility in favor of the credit rating agencies which must be busted. The following is a proposal in that direction. http://bit.ly/bnG6gH

    To, in any other way improve the quality of the credit ratings is of course good, but will unfortunately only put us on the very slippery slope of trusting them even more.

  29. Congress has it all wrong. The answer to the rating agencies is not more regulation but stripping them of freedom of the press protection and treating them like auditors. Put the fear of lawyers in them. Doesn’t mean they cannot make mistakes, but it does mean they mus answer to a higher standard, audit loans and prove they are performing due diligence. Other than than gov’t should de-emphasize ratings, especially for structured securities where assumptions play to big a role.

  30. James Kwak writes “His amendment seeks to eliminate but not replace credit ratings in regulation. If you try to replace something with nothing, you create a vacuum”

    With that simple statement he confesses he has not the slightest idea about what a market means. You do not create a vacuum on the contrary instead of leaving the hole full with mostly three credit rating agencies, which has to leave a lot of space, you fill it up with thousands if not millions of different opinions. The credit rating agencies would not disappear but only return to what they used to do before Basel regulators empowered them.

  31. I believe those are Mr. Witt’s words you are quoting there. I’m not sure if Mr. Kwak agrees or not.

  32. Bayard Waterbury

    Mr. Witt, this is an interesting, well conceived post. Of course, I knew before hand what the agencies did, and, certainly am familiar with their failures. Perhaps the largest problem is that, prior to the discovery (during and after September 2008) that junk bonds had been rated AAA, and that this created a situation in which many investors, especially in derivatives, were essentially cast out to sea.

    What I see as the single largest problem, regardless of incentives, scales, etc., in the restoration of trust in these bureaus, is that they make a concerted effort to carefully define the meanings of each category/scale, and that they use the best possible and thorough analyses to reach conclusions regarding the rating issued. As with all things in which trust is a vital part of the service or product in business, once trust is sacrificed to greed, it is immensely difficult to restore.

    I would note a couple of additional things:

    First, no agency should be concerned with the time it takes to develop a valid rating for a specific security. If it takes a year, so be it. Second, if there can be no resonable degree of certainty established at all, even with intense analysis, then the agency should issue a No Rating (NR) on it, so that investors will know that there is no reliable measure that can establish performance expectation.

  33. Re: @ Bayard Waterbury____Man,…that last paragraph says it all – great, and thoughtful analysis.

  34. I stand corrected, my mistake. I now refer my comment to Mr. Witt.

    By the way, for every correction of an overrated credit, there might result an underrated credit which also causes a cost.

  35. The Senate passed the financial reform bill 59-39. The talking point is when thereconciled bills reach Obama for signature. One piece called for July 4th. This bill got moved to final vote wikthin 48 hours of the closing of the polls in primary voting states on Tuesday. They better get the reconciled bill passed and on to Obama a bit before Super Tuesday primaries. The big play on Super Tuesday is a huge chunk of House incumbents who should be mighty nervous.

    Here is a very back door look at market opinion. A very interesting piece. The market of morons by implication.” Knowledge,Truth and Human Action:America Hits the Wall. By John Kozy at Global Research. This one is fun.

    http://www.globalresearch.ca/PrintArticle.php?articleId=19190

  36. Beings that we have shadow banking, off balance sheet transactions, and derivatives which don’t require any capital I guess this means all investment banks must be NR from now on.

    No arguments from here.

  37. You got it in one. Easy as pie. You want to make money rating? Then, you’re liable. Go ahead, charge more…

  38. I tend to agree with this. The problem is the credibility the rating agencies are given with a stroke of the pen. This puts them up in the ivory tower with the banks. We saw what happened. What further information do we need?

  39. Sen. Specter had an amendment to overturn the Stoneridge case, making secondary actors liable for aiding and abetting securities fraud. This terrible 5-4 SCOTUS case immunized the Enron banks, basically, for aiding and abetting fraud (with intent). This has everything to do with accounting, lawyers, bankers, off balance sheet, SPV’s…the whole farm of fraud.

    Simon and James could fill a book about this single case and single bill. Yet, it gets zero press or publicity.

    The 5-4 would also immunize the rating agencies if deliberate fraud or scheme were found. (it still could be). Imagine not being able to sue because they’re immunized. The dissent in the SCOTUS case was long and angry for tampering with tort liability for the first time in U.S. history.

    This case laid the groundwork for FRAUD.

    You may not like Specter, but this was a fantastic amendment supported by all the pension funds, investors groups, etc. It was strongly opposed by banks and insurance companies. All week we’ve been watching. It didn’t happen after he lost him primary, it lost some juice.

    We need to pass this.
    Call your Senator.
    SA 3994

    http://www.kstreetresearch.com/documents/051210Amendments/SPECTERAMENDMENTSA3994.pdf

  40. OhReginaldIDisagree

    Why not have the ratings agencies rate less, or only a slice of securities? Then have those who sell the securities standardize them as similar to ones already rated?

  41. My vote is with Jake Chase on this one. A transparent and deceptively simple remedy:

    “Prohibit the purchase of structured products by banks, insurance companies, mutual funds, municipalities, etc. Restore Glass Steagall, let the investment banks buy and sell this drek among themselves, and when one or more of them explodes, sayonara and good riddance!”

    How does reforming the CRA’s help if the financial products being rated are instruments for casino banking? Why bother to rate “drek” in the first place?

  42. James Gornick

    Think, on another note, Not to Far-fetched off subject.

    Need to review this one little pesky thing. Pesky, because it keeps flying around looking at you. It just can’t seem to kill it. You guess it. I thought the Banks where the deep problems and rightfully so.

    The brother of another “Mother” of bandits is also a loose cannon and can take this economy down with it just as quick.

    You guessed it, The health care reform just passed by our folks up on the hill gave all the corporate structures the green light.

    SAY THAT ONE MORE TIME SO EVERYONE CAN REALLY READ IT CLEARLY…

    They gave the green light to every corporation. Every corporation over the size of 50 or more employees to wipe off , from below the boardroom or executive levels on down, all healthcare benefit coverage they provide to each employee off their books for the price tag of the $2,000 pieces of dollars (silver).

    It does feel like American taxpayers, and those especially that actually are still working and have health Insurance. Let me repeat that; and underline choice of Health Insurance.

    This is all about to take a serious and drastic change for what is hoped for the better, but one look at Greece and all bets are off if the Government has anything to do with the austerity of caring about my ultimate choices of wellbeing.

    Talk about a wake-up call Ma & Pa America. What,, they aren’t going to let me choose no more Pa? I learned when Mom Ma is not happy then Pa can be a tough person to be around, hence, the riots in Greece and the social confinements seen in other places around the world. Remember, we call this “Austerity measures”, or we can call them Healthcare reforms.

    We cannot allow and we need to revise the health reform law to add a bill. A bill to raise this tax penalty as now held in the current health reform bill as a onetime charge off for a quarter per employee of $2,000 dollars.

    We propose it be raised to at least $75,000 dollars due for two reporting periods equal to be no less than $150,000 per each employee. This would be paid in advance if such company wants to force such employee off the health insurance roles of their plan benefits they are scheduled to provide.

    I like to call it the double jeopardy clause. This just might take care of all those corporations out there that might be thinking of jumping ship, or what is also called the Judas of selling out your fellow man with a kiss. A kiss of Pieces of Silver that represent the dollars of corporate greed of the human unit that brings ultimately the continued bottom line ROI and all the other things that has made the corporation be able to look back throughout its history and hopefully be able to smile.

    My messages are to rally a cry across America that we went Healthcare reform and the ability to have our dignity of choice…

    Peace, I am out of Here…

    Keep God in Your Heart and Always in your Mind….
    James G.

  43. Unfortunately in the real world, forbidding things does not eliminate behaviours. It often makes people more devious, and makes them hide things a little better. In fact, forbidding things can actually increase a behaviour. So no, the solution is not to eliminate compensation, the solution is to eliminate the agencies.

  44. Well, well, well, this is a curious development.

    Lord Scrunchington points us to some smoking guns wrt the BP disaster:

    http://www.thomhartmann.com/forum/2010/05/smoking-gun-bps-deep-horizon-mess

    http://www.nola.com/news/gulf-oil-spill/index.ssf/2010/05/costly_time-consuming_test_of.html

    Now check out this fellow, the Man From Nalco:

    http://phx.corporate-ir.net/phoenix.zhtml?c=182822&p=irol-govBio&ID=139045

    Used to work at BP, helped create BP’s Russian unit, director at CSC, which means he’s locked into the top of the military & intelligence world, joined Lehman Brothers as an “advisor” in 2003, just a scootch before the shtf. Was a director at BOC (now Linde Group) and Diageo, which sells booze.

    At one point at least, he was a member of the (gag) World Business Council For Sustainable Development, founded by this fellow:

    http://en.wikipedia.org/wiki/Stephan_Schmidheiny

    Catch the part about being a major donor to the Peterson Institute? Hmmm.. isn’t someone else we know affiliated with the Peterson Institute? With a background in Russia?

    Mr. Petrossian, please come do a guest post and lay out the broad strokes for everyone soon.

  45. I couldn’t agree with you more.
    The PBS NOW investigation of the Rating Agencies, where beginning in 2001 S&P took bundles of bad apples and using mathematical magic turned them into CDO’s with a Triple A ratings is shocking, and from my perspective should be criminal.
    Credit and Credibility video: http://www.pbs.org/now/shows/446/

  46. Don’t much see the value in rating agencies.
    They don’t have faster computers
    They don’t have smarter people
    They don’t have inside information

    Therefore it’s clear that they don’t have any special opinion. They only exist because of government regulation which they monetize for their own benefit.

  47. the.Duke.of.URL

    Here are two other suggestions.

    James Galbraith: randomly assign rating to agencies. If this doesn’t work, eliminate them.

    Re the first part, it would be easy to make sure that no agency was selected more than was thought appropriate. Re the second part, I don’t know if he was being serious.

    Charles Calomiris: the best thing to do I think is to provide two links

    The first – weith Mason, about the conflicts of interest and low quality of ratings:

    http://www0.gsb.columbia.edu/faculty/ccalomiris/papers/Calomiris-Mason%20Ratings%20Draft%2020100414s%5B1%5D.pdf

    The second – about the debasement of ratings:

    http://www0.gsb.columbia.edu/faculty/ccalomiris/RatingAgenciesE21.pdf

  48. If everything was NR then we would be back to those good old days when our bank regulators did not discriminate against the natural clients of our banks, the small businesses growing to be able to access the capital markets, instead of favoring, by means of those generating lower capital requirements for banks, those who have already made it and have a good credit ratings… and so I am of course in this sense all in favor of NR for all.

  49. If you really want to talk about magical mumbo jumbo:

    Try to make sense on how the regulators set the risk-weights that determine for instance that a loan to a small unrated business is risk-weighted at 100% which causes a bank having to hold 8 percent in capital when lending to it, but in the case of a loan to a corporation rated AAA, or to a country like Greece that until quite recently was rated A, and are risk-weighted at only 20%, then only 1.6 percent in capital suffices.

    Where did the regulators get those 100% or 20% risk-weights from?

    Basel Committee has published “An Explanatory Note on the Basel II IRB Risk Weight Functions” and reading it only reinforces the urgent need of introducing outsiders to this close circle of regulatory insiders.

    That Explanatory Note, July 2005, states that the risk-weights were developed with a “confidence level of 99.9%, meaning a bank is expected to suffer losses that their capital on average once in a thousand years”

    How come that confidence level did not last for two years? Who authorized that confidence level? I for one know perfectly well that, if the world would regulate their banks under the assumption that they would fail only once every thousand years… it might as well be dead and buried.

    Why we do we not debate these absurd risk-weights? Not one single post on that issue in Baseline. Is it because those risk-weights are not those bank oligarchs Simon loves to attack but some of those PhD´s university oligarchs (from MIT also) to whose group Simon belongs or wants to belong.

    Is it Basel…ine?

  50. A loan to a small unrated business is risk-weighted at 100%, which causes a bank having to hold 8 percent in capital when lending to it, but a loan to a corporation rated AAA, or to a country like Greece that until quite recently was rated A, is risk-weighted at only 20%, in which case 1.6 percent in bank capital suffices.

    Where on earth did the smart regulators get those 100% or 20% risk-weights from? Who gave the regulators the right to discriminate in this way?

    I challenge Simon Johnson and James Kwak to try to answer those fundamental questions in at least one post in their Basel…ine

  51. No surprise here, “Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.” Pressured to Take More Risk, Fannie Reached Tipping Point:http://www.nytimes.com/2008/10/05/business/05fannie.html

  52. engineer27

    It’s “Basel Core Asinine”.

  53. Thomas A. Slobko

    Because in one case the banks are on the buy side and the other case they are on the sell side. And the banks rule! :)

  54. Are capital and liquidity rules for the banks out of the domain of the US Congress? http://bit.ly/cI6j9o

  55. Mr. Witt, there is a much deeper problem than the ones you discuss:

    “(2) BB

    Transparency is good except when it isn’t. Rating agencies have been sharply criticized for revealing their methodology and thus allowing investment banks to “game” it. You cannot have it both ways. If a CRA has a transparent methodology, issuers or structuring bankers will use that knowledge to get better ratings. On balance I think transparency is good but issuers and underwriters will express strong opinions about anything that adversely affects them so investors and the SEC staff (see (1) above) need to voice their opinions about rating agency methodologies as well.”

    Don’t take this personally, but current statistical methodologies are useless. This isn’t about probabilistic statistical models and their ability to calculate risk, and you need to stop thinking it is.

    Modern trading systems, computerized as they are, are highly nonlinear. Using statistics to estimate the probability of an excursion to a riskier trajectory is the equivalent of mathematical navel gazing. That’s because the systems tend to look like this: http://upload.wikimedia.org/wikipedia/commons/thumb/e/ef/Lorenz_attractor_boxed.svg/519px-Lorenz_attractor_boxed.svg.png

    I defy you to pick a wing and then tell me which trajectory will continue on that wing, and which will move onto the other. Moreover, without precise starting information you can’t even tell which orbit you’re sitting on. By precise I mean zero error. That’s not obtainable in this universe.

    This is what we’ve created: an automated environment with tens of thousands of trades a second, trades that have triggers to fire them on certain conditions, many of them with strong negative feedback (think naked default swaps here). Your statistics are doing nothing more than modeling a handful of these orbits on one or the other wing, and what the likelihood is of moving between them. I’ve mentioned this before on this site: Nassim Taleb’s “The Black Swan” barely does justice to this state of affairs.

    What’s needed is much, much simpler. Forget about the methodologies. Use all the information. When the trade’s are made, all the little bits of debt and equity that go into the derived instruments would be tagged and available on the Internet for all to see. Open source trading. It will work in a flash. It is, moreover the very definition of transparency. It’s so transparent it will immediately gut these false markets of their absurd investment valuations.

    What we witnessed two years ago during the meltdown was more than likely a transition from one wing to the other. This trading system, in all likelihood, rides around on one of these things in some higher-dimensional space. The traders and the ratings agencies are screwing with a system they simply don’t understand.

    My proposal is simple. Networked computing power got us into this, and it can get us out. But no more risk equations. They’re worse than useless. They’re dangerous and delusional. This is not statistics 101, nor is it multi-linear regression.

    It’s nonlinear dynamics. The popular name for it is chaos.

  56. “It’s nonlinear dynamics. The popular name for it is chaos.”

    In other words it is the market!

    And so let a thousand opiners bloom http://bit.ly/bnG6gH

  57. Norm Cimon Writes: “What’s needed is much, much simpler. Forget about the methodologies. Use all the information. When the trade’s are made, all the little bits of debt and equity that go into the derived instruments would be tagged and available on the Internet for all to see. Open source trading. It will work in a flash. It is, moreover the very definition of transparency. It’s so transparent it will immediately gut these false markets of their absurd investment valuations.”

    Interesting idea. This might be the anti-thesis of black box trading (dark pools).

  58. It sounds interesting, but this is about more than transparency. Let us not forget the issue related to derivatives and slicing and dicing that it should be part of the human rights of any debtor to know exactly who his creditor is.

    The relationship between a debtor and a creditor should be clear and not murky. I believe that a strong society requires for debtors and creditors to know each other. This is by the way another one of the issues that are being ignored in the financial regulatory reforms discussed.

  59. @Professor Gary Witt,

    Open source trading. I really like this concept. Any hope of this being considered by the regulators?

  60. And for me… Open source credit rating!!!

  61. The famous phrase scientia potentia est is a Latin maxim “For also knowledge itself is power” stated originally by Francis Bacon in Meditationes Sacrae (1597), which in modern times is often paraphrased as “knowledge is power.”

  62. Yes, but knowing things or having access to information does not mean the same as being knowledgeable.

    Also, while I an ED at the World Bank, there was a lot of talking about the “Knowledge Bank”, and I often found reason to beg for less knowledge and more wisdom.

  63. open source trading = open source credit rating