I’m drafting a post for The Hearing on credit rating agencies (the ones who gave AAA ratings to all those CDOs). The CEO of Fitch is giving this prepared testimony tomorrow. Here’s the question: Can anyone find anything in there that constitutes a constructive suggestion for how regulation of rating agencies could be improved? Or is it all just self-serving insistence that there is no problem?
(My favorite part is on pages 6-7 where he says, effectively, “Don’t regulate us – regulate the issuers and underwriters instead!”
By James Kwak
The Baseline Scenario 
Has anyone ever done a serious study of how quickly regulators or raters in any industry can be coopted if they enter their jobs with a genuine commitment to honesty? Maybe they really don’t need to study it because the answer is obvious?
A couple ideas. I’m definately a n00b when it comes to financial issues, but just tossing darts out.
1 – Government regulated rates paid to credit rating agencies. Either by tying the fees to a percentage (or percentage scale) of whatever they are rating, or a teired system that is related to the size of the company they are doing the rating for. This limits the “shopping around” that was done to basically Bribe companies to give them a AAA rating. This idea seems a bit heavy handed though, and tough to get through in our “free market”.
2 – Have the government come up with a credit rating company “Score”. (Hell, if consumers can all be identified by a credit score, why not these yahoos.) Depending on how accurate a credit rating company is, they can get a score based on their performance, which would be public. Also, using this system, if a certain company over-rates a certain number of CDO’s that default, regulators could step in and check for fraud/kickbacks. Then again, that might not even be necessary, since the government “score” could be enough to drive a fraudulent company out of business, by having a Failing grade.
The score would need to account for things such as fees they charge (are they out of line of average rates?) the diversity of their clients (do they only have one client who constantly gets high ratings?) and accuracy of past ratings (probably the least important of the three items). I’m sure there are other things that would need to be considered in their “rating”, but these seem to be the biggest failures of the rating agencies.
If this surprises you, then you have missed the key premise of the rating agencies’ apologies. They do not see their ratings as having the status of a valuation or as a substitute for due diligence/independent credit analysis. They see their ratings as mere opinions protected by the First Amendment (you know, kind of like a restaurant review in the local newspaper). From their perspective, it is not their fault that regulators or market participants have given their ratings a status that rating agencies did not intend for the ratings to have. (Not that they are going to argue with how the ratings are used… it is good for business, after all.) But they’d argue that subjecting them to additional regulation would treat them as if they are something that they are not and violates their right to free speech. So why would they make suggestions for additional regulation?
They do more than just “not argue with how the ratings are used”. From the prepared testimony linked above:
At the same time, a number of commentators have spoken on the topic of the market’s perceived over-reliance on credit ratings. To a certain extent, we agree with this premise…
…
One proposed remedy for this is to eliminate the use of ratings in regulation or to eliminate the NRSRO concept altogether. While deceivingly simple, we believe this proposal warrants several comments. Ratings have been used constructively in many places in regulation, as they are an important common benchmark.
(etc.)
They definitely want to have their cake and eat it, too.
The whole document is hilarious. In a tragic way.
I fully believe that rating agencies should face the same threat of shareholder lawsuits that auditors face. Nothing forces adherence to professional standards like the threat of litigation. I also argue that rating agencies have a greater impact on one’s day to day investment decisions then an audit opinion. http://accountonomics.blogspot.com/2009/04/not-all-shareholder-lawsuits-are-same.html
If I were advising the rating agencies, I would tell them not to even bother going down that road. Lawmakers understand that ratings are a convenient proxy for creditworthiness when drafting legislation, and drawing their attention to that fact only invites the suggestion that they suffer additional regulation.
I would keep the martyr posture and insist that they find something else to use in their legislation. It wouldn’t change anything, because there is no convenient substitute.
How about counsel them to just go away?
I can’t tell if you agree with that argument, or sympathize with it, or are just pointing out what the argument is.
I think that a company creates something becomes a de facto standard that has controlling authority in an industry – even if it that company did not seek to have that authority – it still can become subject to regulation. Actually, anything can be subject to regulation, so long as it doesn’t violate the Constitution. So I don’t buy the “we’re just minding our own business” argument.
The First Amendment argument carries more weight, but there are ways around it; Eugene Volokh suggests one in his testimony.
I’m just pointing out what their argument is and why you should not expect them to come up with any suggestions as to how they could be better regulated. I wouldn’t say that I agree with them and I certainly see the sophistry involved. Strategy just isn’t one of their strengths.
Personally, I don’t think the rating agencies are the great evil that people make them out to be, but I never gave them much credit to begin with. I don’t really see them as corrupt so much as inept. If you ever want to know how an asset class has performed in the past, read a ratings report. (I say this as someone who reads a lot of them.) If you want to know what risks the investment involves, do some research and apply some common sense.
People want to blame the rating agencies for a lot of this crisis, and it is true that conflicts of interest are embedded in their business model and that many of the ratings on complex transactions are effectively negotiated. Sure, they had an important role in the securitization process, but I’m not sure they are an essential element. They just made it really easy to throw money around.
But some of what the rating agencies are saying is also true. People do make investment decisions based on ratings alone when they should actually care about what they are investing in. This reinforces the rating agencies’ bizarre status in the financial world, but it is not entirely their doing.
It probably would be a good thing to change the way rating agencies are compensated. It’s certainly better than nothing. But honestly, the government can’t tell market participants how to judge creditworthiness, and what happens with the banks is far more important.
I don’t buy the ‘blame the ratings agency’ meme.
As with secured consumer loans, the collateral must be insured at a full recovery basis. If a used car loan is secured by a car AND comprehensive insurance, the loan is pretty safe: safe enough to sell as an investable loan.
It is my understanding that all MBS included in a CDO had to be protected by ‘insurance’ via CDS. If the principal of the underlying loans was protected (albeit by a counterparty), the loan pool was safe, and, hence, the CDO MBS pool would be safe. How could it not be safe? It was protected by the CDSs. Now if the counterparties are weak, that is where investor due diligence comes into play. Same is true on consumer insurance-protected loans. DD is needed to value the insurance. Sounds safe unless the claim is rejected. I’m not sure the above described used car loan would be as safe if the insurer was Bob’s Fly-by-night auto insurance, either (or Bob’s Fly-by-night hedge fund, for that matter).
The rating is not the same as a bond, and the ratings agency clearly stated that ratings on structured products were a unique type of rating. How could they not be? What would a rating on a bond be if it required CDS protection? It doesn’t come into play with a standard bond rating. The protection isn’t part of a bond rating, as it would make all bonds AAA. But with structured products it does come into play. They’re protected by ‘insurance’. Why should the AAA rating be so suspect?
I’m not a standard defender of structured products, and have been a long critic of CDS irregularities. But the facts are there, and the ratings agencies were working within the guidelines the system has in place.
I applaud you and Simon for this dialogue, but can you please include the relevancy of the underlying protection requirements for inclusion into CDO pools when discussing this, otherwise it becomes an irrelevant witch hunt.
I’m all for finding the witches. Let’s just look in the right direction.
On another more important topic, why don’t you attack the speculative nature of derivatives trading? If a speculator can buy a CDS on a bond they don’t own, then demand full principal repayment on default claim, isn’t that like buying insurance for a 1966 Testa Rossa, then filing a claim that it was trashed and getting full payment without producing a trashed car (never having actually owned the car which you were paying short term insurance premiums on)?
Regulate options and swap purchases to only entities that hold the underlying security to be protected, and that eliminates speculative derivative trading. The CBOE will shrink and financial services companies will have 1/5 the business, and they will fight this tooth and nail, but the only real solution is to completely eliminate speculative options and CDS purchases.
Options and CDS were originally intended to act as protective insurance products. As soon as they began being traded as speculative bets, the whole risk distributing nature of the product was destroyed.
Balls in your court, Jim and Simon.
What I don’t understand is how the current fee system is allowed. The rater gets paid by the ratee? Come on, why is anyone surprised that risk was underestimated? I find it more surprising that there haven’t been more problems.
Just think of the success that Joe Public would have suing a rating agency, or any of the oligarchs. The ratings agents/agency/oligarch would not have to address the substance of the charge/claim, only expend a small fortune raking through the technicalities until the suit dies of inadequate funding. This also applies to governments filing suit, since their resources are limited.
The Fitch statement says “Due diligence is not currently, nor should be, the responsibility of credit rating agencies. The burden of due diligence belongs on issuers and underwriters. In that regard, we support the concept that issuers and underwriters ought to be required to conduct rigorous due diligence on the underlying assets that comprise asset backed and mortgage backed securities offered or sold in the U.S.”
Question: Were any regulator or investor in securities collateralized by badly awarded mortgages to the subprime sector aware of the extent to which the credit rating agencies were NOT doing a due diligence?… Is nothing of a due diligence process required for rating? How can you rate without ascertaining that a due diligence process has been performed? If these types of now suggested due diligence take place do we need the credit rating agencies? If a credit rating does not imply any due diligence how on earth could it imply a permit to a bank to leverage itself 62.5 to 1 on loans assigned a triple-A rating?
I’m curious. Just what regulation do you propose that will make things better?
Would it be feasible to create a credit rating fund into which all companies seeking ratings would contribute and out of which the credit rating agencies would be paid. This would make it difficult to tie a particular rating to a particular company, and less likely that a company could “buy” a rating.
If the gov’t wants reliable ratings, why not just pay for them? Hire ratings agencies with the proviso that they not also receive payment from private parties. Hire a few so that their ratings can be compared, and they will have the threat of being fired.
I think that a lot of gov’t privatization sucks, but this seems like a sitter to me. How in the world can we expect effective regulation of raters who have intrinsic conflict of interest? The regulators would almost have to do ratings themselves. Instead, hire raters without those conflicts of interest to compete among themselves.
As for the current ratings agencies, they have not exactly covered themselves with glory. Why not hire some new blood?
Can’t say it better than “bond girl”
But I would point out something – it does kind of shoot in the foot the idea of “economic man.”
Here you have companies that up front state that your guess is as good as theirs when it comes to what will happen to bonds. Everybody knows that the rating is paid for by the entities being rated.
AND THAN, people pay attention to these rating??!?!?
Whatever the number one question to any credit rating agency in any hearing on this financial crisis should be the following:
Do you feel you really deserve that the bank regulators should trust you so much that they allow a bank to leverage itself 62.5 to times to 1 on loans that carry your AAA stamp of approval, and in some extreme cases even up to 179 to 1?
They will most probably not make that question because most experts who should have been able to forewarn the crisis but never did, have not the slightest idea of what the minimum capital requirements for banks that were designed by the Basel Committee really meant.
Indeed why do you only contemplate credit rating? What does it really mean? Why do you not go for decent jobs creation rating? Fighting climate change rating?
The ratings agencies should be free to publish whatever ratings they want – no matter how preposterous. The corruption comes from basing banking regulation on those ratings – essentially, the banks were able to purchase indulgences that allowed them to move their sins off the books by getting them rated as good works. Where is Martin Luther when you need him?
Bond Girl,
Thanks for your posts on this. They have helped my thinking.
Tony Rockwell… You are right on the dot!
The regulatory clergy in Basel are clearly the ones guiltiest for this whole crisis.
Can you imagine they even got to the point of giving out indulgences that meant that banks could leverage some operations 179 to 1… as longs as they got some AAA ratings and full-filled some other criteria
But you know most if not all experts like those in this blog and those who will be questioned in Congress never did say a word about what the bishops were up to in Basel, I guess they were and still are too afraid of an inquisition… or they just want to be the new priests.
Underwriters Labs has run on that business model for decades, and do about the same function as ratings agencies – except for physical products, not financial products.
One of the reasons that their model works well is that they also produce standards. If you’re a maker of copper wire and want the UL seal, you go look up what characteristics the metal and insulation need to have, and you manufacture to those standards. UL checks your work and gives you the seal. They also, working with manufacturers, develop and test new standards.
Presumably the credit-ratings equivalent would have to also publish standards; if your mortgage product has these characteristics, it will be AAA (or BBB, or whatever). The important part is that, if a bank comes up with some new product not covered by the standards, the ratings agency should say “not ratable”. If the bank wants to sell it unrated, fine; the product’s subsequent performance will be important data as the credit rating service decides how to assign ratings to this new product.
When Chris Rogers referred (elsewhere on this Blog) to leveraging at 30 to 40 to one dollar, it was eye popping.
Per Kurowski now states there was leveraging at —62.5 to 1 and 179 to 1 —. I take it Per’s mission is to expose the Basel Committee for its role in this financial mess.
These leveraging ratios defy common sense.
A loan to an AAA to AA- rated company is weighted at 20% which means that 500 in loans count as only $100. Then the $500 divided by the basic capital requirement for $100 which is 8% or $8 results in an effective marginal authorized leverage of 62.5 to 1. It gets worse… the 179 to 1 is the result of a 7% risk weight. And in fact truth is that it could be even worse since of those 8% basic capital requirement only half, 4% is for real, real.
Of course the rations defies common sense… how can I explain it? You just feel like sitting down and cry… especially since so far into this crisis most of the blabbers do not take their time out to read about it all… I guess it is because it is much more fun to blame bank oligarchs
It seems to me these credit rating agencies could be constructed as independent third-party agencies. Their mandate would be to protect the lender. Following this line of thought, therefore lenders would contribute to a pool of money to finance these hypothetical agencies. In fact, these hypothetical credit rating agencies would operate as not-for-profit organisations.
A non-economist riffing here.
Any thoughts?
Per, I can follow your math and this is truly astonishing. Maybe the Oligarchs and the Basel Committee both need to be exposed.
Indeed there are many ways to set it up. Either you investor pay them and the credit rating agencies will work more for you, or they, the investors pay them, and you are aware that the credit rating agencies might be biased. Anyway works. What does not work though is for some regulators to force the criteria of some few credit rating agencies upon the market by giving so much structural importance to their opinions, and as is currently done with the minimum capital requirements for banks concocted in Basel.
I just can’t resist adding a “here! here!” I think fitch’s testimony really took the cake for gall. Joynt is terrified that someone might hold the rating agencies liable for their opinions. The notion seemed just too shocking for him. He also said that if agencies didn’t do a good job, then clients would leave. Amen. I hope he’s right. I hope investors realize they don’t need the agencies and that it would be cheaper to hire their own analysts to find decent investments.