TARP for Rating Agencies

I would have thought that the credit rating agencies would be at least one group that everyone could agree to throw under the bus. We know that the powerful chieftains of Wall Street are trying to pin the credit crisis on rating agencies – see page 3 of JPMorgan’s blame-shifting attempt, for example. Yet the new Financial Regulatory Reform plan has almost nothing on the subject. Apparently the rating agencies, too, are Too Big to Fail.

Reuters catalogs the provisions relating to the rating agencies. Here’s the summary:

The plan urges Moody’s Corp’s Moody’s Investors Service, McGraw-Hill Cos Inc’ Standard & Poor’s and Fimalac SA’s Fitch Ratings and others to bolster the integrity of their ratings, especially in structured finance.

It also calls for reduced conflicts of interest and for regulators worldwide to tighten oversight.

But the blueprint does nothing to address what critics call the industry’s key shortcoming: That the biggest agencies are paid by issuers whose securities they rate, creating an incentive to win more business by assigning high ratings. . . .

“The overall impact of existing and proposed regulatory changes on rating agencies is extraordinarily easy to summarize: They reward abject failure,” said Jonathan Macey, deputy dean of Yale Law School.

Also see the Huffington Post, which has this understated but damning criticism: “Today, the agencies welcome the government proposals, saying that they favored improved ratings quality and transparency.”

Perhaps this is one area where Congress can improve on the administration’s plan.

Update: Krugman:

The plan says very little of substance about reforming the rating agencies, whose willingness to give a seal of approval to dubious securities played an important role in creating the mess we’re in.

By James Kwak

45 thoughts on “TARP for Rating Agencies

  1. Again, it’s not rocket science, you well know and have shown here clearly James. That’s why we love you and Simon’s site so much is you fight the good fight. It’s as simple as making the USERS of the ratings pay the ratings agencies. When the agencies are paid by the issuers of the same securities they are rating, you know the risk scenarios all of the sudden look very rosy. An amazing thing isn’t it?? I guess Larry Summers and Timothy Geithner were sleeping when their economics professor was teaching THE BASIC DEFINITION OF INCENTIVE, because they don’t seem to think it’s important to take that basic knowledge and apply it in their jobs now. Maybe I’m being to harsh?? Maybe they know VERY WELL what the basic definition of incentive is, but the thought of making Kenneth Lewis or Jamie Dimon cry was just too much for them.

  2. On Planet Money (or This American Life, I don’t remember), the rating agencies seemed to trying to push the blame off on the fact that certain groups require a certain rating of the financial products they hold, so when all the AAA rated products started to be downrated in the credit crunch, most of the investors were forced to sell, causing further downfall.

    I think that if this is the case, this is something that should not be left to a for-profit company. We wouldn’t tolerate the FDA being run by Monsanto, or a company that gets paid by Monsanto or Phizer.

    The government should do the ratings (and should get a government salary). I would think an Adversarial/skeptical approach to business is what you want for new financial products.

  3. Reading my post, I was unclear:
    “The government should do the ratings (and should PAY a government salary to it’s employees).”

  4. What about all the Federal, State, and Local laws and regulations that direct public entities specifically to invest in securities with a minimum rating? Those directives are a big part of the problem, because they create a captive market for whatever bizarre instruments I-bankers can dream up.

  5. It does not cease to surprise me how little most critics understand about ratings agencies. Let’s recap:

    1) You link to an article that quotes critics claiming that the industry’s key shortcoming is the issuer-pays model. Really? Where is the proof for that? If this were true how come it only became a problem in recent years? The issuer-pays model has been in place for decades. Also, if this is true why did it only affect certain structured finance ratings but not corporate, or bank, or sovereign, or public finance ratings?

    2) Regarding my last question on point 1), do these critics know what rating agency default studies are? Have they read them? If the answer is no to either one, how can you comment on this topic? The fact is that the rating agency errors are concentrated on one specific type of product.

    3) Critics don’t seem to know what ratings even are. For example, you will read that rating agencies missed Lehmann. But ratings are probabilities and probabilities can not be prove wrong by single events. The default rate of banks was not, in fact, high at all.

    4) Critics don’t know how ratings are calculated. In the bank example above many will answer “yes, but the low default rate was due to government bailouts” blissfully ignorant that bank rating agency methodology explicitly includes expected government support.

    What then explains the rating agency mistakes on certain structured products? I suggest two main ones. First, they missed the massive drop in housing prices and the economic impact of that, as did practically 99.99% of market experts. Second, more competition among rating agencies (Fitch as the 3rd agency) allows ratings shopping, something that did not exist when only Moody’s and S&P reigned (and almost all bonds had two ratings).

    Given all of this I am curious as to what reforms you recommend.

  6. Solution is simple: Trash the NRSRO requirement. No such license is needed to rate stocks; why mandate for the easier analysis of rating debt? Let the market decide whom to trust, not the government.

  7. In other words, make ratings shopping even easier. Many Latin American countries did that, allowing almost anyone to create a local rating agency. Do you know what the results were?

  8. Gabriel: you’re missing the bigger picture: removing NRSRO status means that over time ratings triggers tied to those within the current oligopoly will begin to be removed from current contracts… meaning that the market between issuers and buyers of debt instruments will accept others credit raters that the market accepts as reliable. Spreading the wealth to other raters will improve the quality of the competition. Would you trust the government to decide who you should rely on for investment advice?

  9. But that’s exactly what happened when Fitch became a major player. You increased competition but also allowed ratings shopping. The big two rating agencies were historically VERY conservative (look at what happened with future flow structured transactions) and when a third one became an option bankers would play each against the others to get higher ratings.

    My point is not that the curent model is perfect. it is not. My point is that most people who attack rating agencies don’t understand them and basically don’t know what they are talking about. And the second point is that we better make sure that any change does not make things worse.

  10. We are in some agreement, but I am in the camp that the current system is sufficiently imperfect yet fixable to fix now. Abolishing the NRSRO license to compete should be replaced with the requirement to abide by a code of best practices (which addresses rate shopping amongst other issues) that a government agency open to regular modifications watches and enforces. A governmental watchdog role would be much preferred over a sanctioning one. Such could result in a similar process as with financial advisors: a regulated industry in which, although the barriers to entry are low, the ultimate survivors will be those that the market accepts as the most credible and adds the most value. History shows that only through vigorous competition do you generate innovation and real accountability. The current system is unfair, inefficient and produces subpar performance.

  11. The Geithner-Summers plan is NO SURPRISE to anyone who “gets it.” Everything being done is to benefit the banksters: JPM, GS, and others in the big money gaming circles. That includes appeasment, and any appearance of appeasment, toward the rest of us.

    Check out this quote re the ICC & railroads; in U.S. politics, little has changed:

    “The [Interstate Commerce] Commission, as its functions have now been limited by the courts, is, or can be made of great use to the railroads. It satisfies the popular clamor for a government supervision of railroads, at the same time that the supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between railroad corporations and the people and a sort of protection against hasty and crude legislation hostile to railroad interests… The part of wisdom is not to destroy the Commission but to utilize it”

    — (U.S. Attorney General Richard Olney, in an 1892 letter to his friend Charles E. Perkins, president of the Chicago, Burlington & Quincy Railroad; quoted in Robert Fellmeth’s The Interstate Commerce Omission: The Public Interest and the ICC, Grossman Publishers, 1970, p. xiv-xv).

    ~ http://www.landgrant.org/history.html

  12. Everybody here agrees that the main shortcoming stemming from the rating agencies (in this crisis) is about the mis-rating of the structured credit products.

    As someone says, the rating agency offer a useful service of providing financial information that has worked over years. But when they smelt the good opportunity of making more money at the beginning of the century by developping their own business in assesing structured finance, that fact should have been scrutinised and critizised by the regulators.

    From my point of view, an overhaul in the rating agencies business system will be simply not to allow the rating agencies to rate structured finance. All the financial engineering world recognizes that the models employed in the rating agencies where too simplistic to take into account properly the risks inherent to such products, such as the correlation risk for the securization/structured credit products. Most of the time, these models rank a product by giving it a note, among 10 different choice, where a credit model developped in an investment bank displays the market spread at which someone is willing to take the risks (theoritically any value above 0 is admissible). Simplistic methods which do not give an accurate idea of what the risks are is creating assymetric information to the detriment of the risk-takers.

    In compensation, the financial regulator authorities must provide support to investors in structured finance by developping and providing reference in pricing solutions. At the moment, the banks or rating agencies are allowed to do whatever they want (almost I agree) in quantitative methodologies as long as it suits the simplistic capital requirement tests or others pointless controls.

    This will kill the financial engineering and all the geeks which earn a lot by doing maths in the banks. But consensus about the pricing is very important in structured finance and reference models should allow naive investors to have a better idea of the risks they are taking. And if they found it too complicated to pour money in, they just don’t invest which will avoid them to say “We didn’t know!”

  13. Gabriel: “For example, you will read that rating agencies missed Lehmann. But ratings are probabilities and probabilities can not be prove wrong by single events.”

    So, what was the computed probability of Lehman defaulting? 0.000000000000000000000000000000001%?

    They probably use Gaussian models based on past data. Absolutely useless.

  14. The fault does not lie with the credit rating agencies, the fault is exclusively that of the regulators wanting to use the credit rating agencies.

    Though the proposed financial regulatory reform often speaks about more stringent capital requirements it still conserves the principle of “risk-based regulatory capital requirements” and by doing so the New Foundation unfortunately builds built upon the most fundamental flaw of the old regulatory system.

    Regulators have no business in trying to discriminate risks since by doing so they alter the risks and make it more difficult for the normal risk allocation mechanism in the markets to function.

    Financial risk cannot only be managed by looking at the recipients of funds since those lending or investing the funds are also an integral part of the risk. High risks could be negligible risks when managed by the appropriate agents while perceived low risks could be the most dangerous ones if the fall in the wrong hands.

    The recent crisis detonated because some plain vanilla (very simple and straight forward) awfully badly awarded mortgages to the subprime sector managed to get dressed up as AAAs should attest to the previous. This crisis does not grow out of risky and speculative railroads in Argentina this crisis has its origins in financing the safest assets, houses, in supposedly the safest country, the US.

    With this proposed financial regulatory reform I can only conclude that the regulators are dead set on digging us deeper in the hole we´re in.

    Do you know that if a bank lends to a borrower that has been able to hustle up an AAA the bank is authorized to leverage itself 62.5 to 1?


  15. That’s a nice idea, but how would you do that? You would have to license the data and restrict its use to people who have data licenses. That’s a practical model, and it is used for a lot of financial information, but it would mean that individual investors would no longer have access to ratings data.

  16. AIG Failed (in part) because CDSs issued against MBSs that had Ratings that hid the true risk associated with the MBSs. Apparently, these ratings were somehow “adjusted” to include the rating of the issuing agency, thereby transforming a “bad” rating into a “good”/”excellent” rating. The question about how this happened needs to asked/answered. Was this a part of any modeling, or was it an administrative action after the risk evaluation had been completed?

    (Has anyone seen all of the paper work for a failed MBS and associated Rating Agency paperwork posted on the WEB somewhere, so that the details of just one of these “vehicles” can be examined in a public forum? In other words, what did risk rating did the MBS received before the corporate rating was considered? Will the Obama plan change anything, relative to this bit of “business”?)

  17. engineer27: “What about all the Federal, State, and Local laws and regulations that direct public entities specifically to invest in securities with a minimum rating?”

    Agorphobic Kleptomaniac: “certain groups require a certain rating of the financial products they hold, so when all the AAA rated products started to be downrated in the credit crunch, most of the investors were forced to sell, causing further downfall.

    “I think that if this is the case, this is something that should not be left to a for-profit company. We wouldn’t tolerate the FDA being run by Monsanto, or a company that gets paid by Monsanto or Phizer.”

    Indeed. If the gov’t is going to require people to use ratings, the gov’t should pay for those ratings. Testing and assessing products and promulgating standards is something that the gov’t can do.

  18. Per Kurowski: “The fault does not lie with the credit rating agencies, the fault is exclusively that of the regulators wanting to use the credit rating agencies.”

    In this case, perhaps both were at fault. But the regulations by the gov’t requiring the use of privately produced ratings is flawed. It is asking the private agencies to do the gov’t’s work for it. For free.

  19. To the financial institutions AIG did not really sell financial risk coverage as much as the lower capital requirements it could transmit them as an AAA rated company; courtesy of the extremely gullible and naive regulators who should have seen all this coming… (including those working at the IMF)

    The Obama plan does not change anything it is only that the financial market has, at least for the time being, run out of AAA companies offering these CDS and similar coverage; and that is why I hold that Obama and team are sure leaving a very rotten apple in this barrel of financial regulatory reform, namely the minimum capital requirements based on risk.

  20. Rating agencies would like for you to believe that ratings represent “probabilities” of default (implying something purely quantitative and objective), but there is an incredible amount of subjectivity involved in the rating process. Ratings are really just opinions and they did miss the obvious. If you want proof that they missed obvious default risk, compare ratings actions to the CDS market at the time.

    I do not think that how the rating agencies are compensated necessarily involves a conflict of interest (look at the muni market, for example). But it undoubtedly affected the sophisticated instruments, which became a major source of profit for the agencies during the bubble.

  21. Not so long ago I asked my daughter to key in an address in the GPS and then even while I continuously heard a little voice inside me telling me I was heading in the wrong direction I ended up where I did not want to go. That is exactly what the credit ratings do to the financial markets, especially when the regulators create so many incentives to follow them.

    Today we have financial analysts looking at how the credit rating agencies might change their opinions about a company, instead of using their time analyzing the companies and help the market to get a more diversified view.

    The whole system of minimum capital requirements based on risk seems created by an evil mind that is out there laughing at us. For another version I invite you to visit http://www.theaaa-bomb.blogspot.com/

  22. I think it was Simon who said it best – these proposals aren’t making people mad. I don’t think the masters of the universe suddenly saw the light here, so that means that the proposals must be lacking. If they actually addressed the problems, a lot of people should be very unhappy, but that’s not the case.

  23. Some, thinking of the so much in need and the future prospects of the world want a solution, other seem to just want to vent their resentments with a jolly good afternoon at the guillotines

    If there is anyone who has written a 1000 posts in reference to the role the credit rating agencies have played in this crisis, it is me and I dare anyone do prove something different, but, that said, I would be very very happy just seeing the credit rating agencies riding away in the sunset.

    In https://baselinescenario.com/2009/06/18/too-big-to-fail-politically/ there is even someone who identifies himself abominable as Lavrenti Beria and calls to put Simon Johnson´s oligarchs in “concentration camps awaiting the consideration of peoples’ courts” and the sponsors of the blog do not say a word about it.

    Makes you stop to think about what they really have in mind. Whatever, at least we know that this is not the stuff that regulators should be made off.

  24. To be honest q, I hadn’t really thought of how it would be ENACTED. But I think there must be an good answer out there in the economic and financial journals. I’m sure this has been pondered and explored before. I will look online and see if I can find how the USER as payer (instead of issuer as payer) system might be applied. It’s a fair and good question. But one thing we KNOW: Human beings are not going to give low ratings on issues coming from the same people who pay their salary. And Gabriel’s argument that “well we never had problems with ratings in the 80’s and 90’s, so the system was working” is very bogus and lame. JUST BECAUSE THE PROBLEMS (CONFLICT OF INTEREST) WITH RATINGS WERE NOT OBVIOUS ON THE SURFACE IN THE 80’S AND 90’S, DOESN’T MEAN THOSE PROBLEMS WEREN’T THERE.

  25. Gabriel, You should go to the link below, and click on the video, where it says “Credit and Credibility”. The video shows why credit ratings had become a joke. In fact, credit ratings’ failures had very LITTLE to to with housing prices, and ALMOST EVERYTHING to do with Wall Street trying to sell billions of dollars of financial products stuffed with garbage. And you hear it from 2 men who were working INSIDE Standard and Poor’s. So, I think we could say these 2 men have some knowledge of credit ratings agencies and their practices. Here is the link to the video. Go there and click “Credit and Credibility”

  26. “well we never had problems with ratings in the 80’s and 90’s, so the system was working”

    Of course not! It was only when the Basel Committee concocted the minimum capital requirements based on the credit ratings that these credit rating agencies took on such an importance. Also that the financial regulators gave the credit rating agencies such an important job (to be the GPS on risk) exponentially elevated the credibility of these agencies. “If they are good enough for the financial regulators then they got to be good enough for me”

  27. Per, keep on posting ! I am a non-economist, but from what I can conclude, you are calling for a return to common sense. This includes:

    (1) Forget the ratings agencies. Investors need to do their own due diligence.

    (2) Forget Basel. Governments need to apply stricter capital requirements on banks.


  28. Per, keep on posting ! I am a non-economist, but from what I can conclude, you are calling for a — return to common sense. — This includes: (1) Forget the ratings agencies. Investors need to do their own due diligence. (2) Forget Basel. Governments need to apply stricter capital requirements on banks.


  29. On the “Forget Basel” what I mean is that regulators should not get into the business of discriminating between risks as they do allowing for a 62.5 to 1 leverage for banks if the borrower is an AAA rated company compared to a 12.5 to 1 leverage if it is a company without a rating. This mingling with risks creates all type of dangers… among them raising the incentives to dress up as AAA… among them ignoring the fact that risk is an essential component in the development of any society (no woman no cry)… among them ignoring that riskier ventures are always treated with more care than those perceived as less risky… and much more.

    Lets us be very clear… this crisis was not a result of anything perceived as risky… this crisis is 100% the result of some regulators selling the idea and the regulations that with a little help from some human fallible credit rating agencies finance could be made less risky. What nonsense! It turned out (as some of us expected) just the opposite.

  30. Per, I read you blog on why sometimes so-called riskier loans are more deserving. Enlightened that you consider social and environmental factors, for example, important considerations in determining interest on a loan.

    I found a link to an online novel you are writing. (I can’t find again that link because there is too much material to wade through on this blog.) Could you repost the link to your novel.


  31. Let me phrase it the following way… the world has never moved forward one inch financing AAA ventures… on the contrary that only solidifies the status quo… the world moving forward depends on those unrated and certainly more risky projects. But if markets already charge more to finance those unrated and certainly more risky projects, why should the regulators add additional costs to these or subsidize what they believe are the risk free projects.

    The “novel” is just a speculative affair and something that I used to illustrate more in jest our current regulatory problem. You find it here: http://www.theaaa-bomb.blogspot.com/

  32. Thanks Per. To illustrate what you mean about so-called risker loans:

    A-company has an AAA triple-rating and needs financing to build a coal-fired electrical plants. The smoke stacks are state-of-the-art.

    B-company, with no credit rating wants, wants to build solar-panel roof-tops that allows homeowners to sell excess power back to the grid. Due diligence indicates B-company has a very good technology. But B-company will need government subsidies, for a decade, before it will be profitable. By then entire towns in California and Nevada will have solar-panel roofs.

    The AAA credit rating is blind to the environmental cost and benefit of financing. So B-company does not get built. Hence a failure in environmental accounting for the two projects.

    More generally, I think you are saying Basel, a convocation of central bankers, has missed the boat entirely. This is because, under Basel, capital requirements for banks are based on credit ratings. So there is a structural flaw in the world banking system.

    Rather than ban or regulate, the rating agencies, address the structural flaw.


  33. Right! There has to be a much higher purpose for our financial system than just avoiding crisis. “No woman no cry”. (Figuratively speaking of course, I would not equate woman with any sort of crisis, God forbid my wife would get hold of it)

  34. Edit needed …

    By then entire towns and cities in California and Nevada — could have had — solar-panel roots. But B-company does not get financing. California and Nevada opted for nuclear energy. The “sticky wicket” being not only did B-company not have a credit rating, but it got shouted down as “socialist” for requiring government subsidies to get started up.

  35. OK Per, I have a Bob Marley CD and I’ll listen to his song again, “No woman no cry”. Can’t remember the lyrics.
    As for the outline of your proposed novel. There is definitely potential ! Could not stop laughing.

  36. Per, I will take up on this offer at your AAA-Bomb blog. (Once I figure out the tech issue so I can comment.) My God ! You could be another Jonathan Swift.

    I can see the start of a movie here… How about George Clooney as the intrepid anti-hero Molotov … Or better still … the rusty-voiced, cigar-smoking Alec Baldwin ! Redoubtable left-wingers that they are.

    As for film score … you could start with Bob Marley. His song “Africa Unite” is one of my favorite (because it contains an exquisite riff). Let me think about this and I will get back to you at your AAA-Bomb blog.

  37. Ted,

    That’s not the only counterindicator. Not only did the issuer poay model not create any probelms in the past, it didn’t create any problems in other rating segments, like corporates or sovereigns. It’s pretty clear that the issuer pay model as a cause of this crisis lacks any empirical evidence. Not that this will stop journalists and others that don’t know what rating agencies are and do.

  38. Bond Girl,

    Of course ratings have plenty of subjective elements. Rating agencies are quite clear about that.

    As for CDS spreads, they are much more volatile than ratings and have different uses.

  39. Per,

    agree with you re: basel ii and capital requirements.

    another piece of the puzzle is the fact that many leveraged finance vehicles have ratings triggers.

  40. The Ratings Agencies are supported by governments because regulators defer to them in such areas as risk management (e.g. for state pensions investments), municipal bond ratings, and capital requirements.

    However, the Ratings Agencies defy any attempts to be regulated themselves, shielding themselves using a defense of “Free Speech” protections.

    This is a toxic mix: either no official status and clarity that they are offering their opinions after being paid by their issuers [as NYT puts it here, http://tinyurl.com/nytrate, “Four stars, two thumbs up, a must read: Rave reviews like those might seem a bit suspect if they were paid for by the restaurateurs, movie makers and authors being reviewed”), or official status and sensible regulatory requirements.

    Finally, there is irony that professional investors actually love ratings? Why? It is the biggest A$$-covering operation in finance. I bought a load of crap bonds, waa, but it isn’t my fault, Moody’s said they were fine!

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