Famine and Feast
Although the Credit Rating Agencies (CRAs) haven’t been blamed for world famine there isn’t much else that hasn’t been laid at their door. With good reason, for without the co-operation of the CRA’s the vast explosion of securitised loans which eventually imploded in 2008 couldn’t have occurred.
Unfortunately the rating agencies may be the least of all evils, and we can at least trace the paths through which their ratings were compromised. Free market believers, though, should look away now because the failure of the CRAs is another example of market failure. More competition led, not to better ratings, but to a race to the bottom of a very deep pit.
Venerable Agencies
The history of the CRAs is a long story in its own right and is well told by Richard Sylla in A Historical Primer on the Business of Credit Ratings. The companies from which they grew are amongst the most venerable in America, with origins stretching back prior to 1850. The agencies themselves arose out of what was a peculiarly American need to provide market information to investors about corporate bonds. The vast demand for capital to develop the continental interior of the United States and the resultant proliferation of bonds drove the creation of the ratings business.
As might be expected, given that the major rating agencies and their antecedents have been around for well over a century, the record suggests that they were pretty good at bond ratings. It’s possible to compare the agency ratings with a “market rating” which is, roughly, the divergence of any particular bond’s yield from that of comparable securities. As Sylla states, the analysis of this:
Volatile Growth
By the end of the nineteen sixties, following an unprecedented period of high growth and low volatility, the agencies were small and largely insignificant. However, as market stability deteriorated during the seventies this changed rapidly. In particular the use of the CRAs to rate securities increased as the SEC started, in effect, delegating regulatory due diligence requirements to them:
Interestingly the SEC never actually got around to defining the criteria to be an officially recognised ratings agency. Instead they used the stunningly circular test that any such organisation had to be “nationally recognised by the professional users of ratings in the United States as an issuer of credible and reliable ratings”. To whit: to become a ratings agency you had to be an agency that produced ratings. Perfect, and completely circular.
Conflict and Benefit
One potential benefit of this approach is that is helps to manage the complex relationship between asset managers and their owners. By demanding high ratings, which are supposedly guaranteed by the due diligence of the agencies, the owners can protect themselves against their managers investing in dodgy stuff, like self-certified sub-prime mortgages offered on low introductory interest rates. On the other hand, it has been previously noted that contracting out this kind of regulatory function is a bit odd: why only ratings, rather than allowing the majority of financial regulation to be performed by competing market based companies?
Meanwhile the obvious conflict of the agencies' role in regulating their customers with their reliance on the self-same customers to hit quarterly revenue targets was always a potential problem, but oddly enough didn't turn into a real one. The reason for this, it seems, was that up until the turn of the century this wasn’t really an issue because no single client accounted for as much as 1% of the revenues of the agencies and so none of them were able to exert any undue influence. It was only when the rating of structured financial products started to dominate the agency’s business at the beginning of the new century that the problems appear to have started.
Customers (Deceased)
As John C. Coffee, Jr. relates in Ratings Reform: The Good, The Bad and The Ugly:
Market Failure or Not?
While the ratings agencies were largely immune to competition and client pressure their function as a de-facto part of the regulatory system seems to have worked quite well. As usual in finance, if something works for a while everyone assumes it'll work forever, even if the environment changes. When the agencies' immunity was destroyed the fact that there was no one to regulate them was pure poison for the global economy. The ratings agencies turned out to be about as close to a single point of failure for the whole system as you could possibly imagine.
Obviously governments and regulators have now woken up to the risks posed by the CRAs and are furiously figuring out how to close the various stable doors while looking around for some horses to place behind them. The Coffee paper describes the various manoeuvrings in this area, and how these differ between jurisdictions.
Overall it’s not really clear as to whether this was a genuine market failure – and therefore inevitable – or a consequence of the behaviour of the managements of the rating agencies under competitive pressure, such that events could have transpired differently. The suspicion is a bit of both, but it does rather leave open the issue as to whether regulatory functions can ever be effectively outsourced.
Related articles: Complexity in Financial Systems, Going Dutch, The Benefits of Sound Money, It's Not Different This Time
Although the Credit Rating Agencies (CRAs) haven’t been blamed for world famine there isn’t much else that hasn’t been laid at their door. With good reason, for without the co-operation of the CRA’s the vast explosion of securitised loans which eventually imploded in 2008 couldn’t have occurred.
Unfortunately the rating agencies may be the least of all evils, and we can at least trace the paths through which their ratings were compromised. Free market believers, though, should look away now because the failure of the CRAs is another example of market failure. More competition led, not to better ratings, but to a race to the bottom of a very deep pit.
Venerable Agencies
The history of the CRAs is a long story in its own right and is well told by Richard Sylla in A Historical Primer on the Business of Credit Ratings. The companies from which they grew are amongst the most venerable in America, with origins stretching back prior to 1850. The agencies themselves arose out of what was a peculiarly American need to provide market information to investors about corporate bonds. The vast demand for capital to develop the continental interior of the United States and the resultant proliferation of bonds drove the creation of the ratings business.
As might be expected, given that the major rating agencies and their antecedents have been around for well over a century, the record suggests that they were pretty good at bond ratings. It’s possible to compare the agency ratings with a “market rating” which is, roughly, the divergence of any particular bond’s yield from that of comparable securities. As Sylla states, the analysis of this:
“Concluded that agency and market ratings had performed quite well in the first part of the century … Hickman was concerned about the use of agency ratings for regulatory purposes. That use might accentuate financial difficulties in a business contraction, just when measures should be taken to alleviate such difficulties”.This latter point arises because the research showed that agency bond ratings rose and fell with the business cycle, yet market ratings didn’t. Unfortunately the latter were extremely unstable whereas the former, it was suspected, varied because of the sensitivity of the financial ratios in the models underlying the ratings. Of course, this also suggests that market psychology plays its part in the ratings, as the markets are moved by opinion and emotion rather than logic. To say that we're not surprised understates the situation greatly.
Volatile Growth
By the end of the nineteen sixties, following an unprecedented period of high growth and low volatility, the agencies were small and largely insignificant. However, as market stability deteriorated during the seventies this changed rapidly. In particular the use of the CRAs to rate securities increased as the SEC started, in effect, delegating regulatory due diligence requirements to them:
“Interestingly it was around this time that the agencies shifted to the practice of charging issuers for ratings and earning most of their revenue from such charges. The regulatory-license hypothesis would explain this by saying that once an agency rating was important to the acceptance of a new bond issue, in the sense of determining whether regulated financial intermediaries could buy it at all, and under what terms, the issuer has a strong incentive to purchase a rating from a rating agency”.In the real world we call that a conflict of interest. In the securities industry it's a business model.
Interestingly the SEC never actually got around to defining the criteria to be an officially recognised ratings agency. Instead they used the stunningly circular test that any such organisation had to be “nationally recognised by the professional users of ratings in the United States as an issuer of credible and reliable ratings”. To whit: to become a ratings agency you had to be an agency that produced ratings. Perfect, and completely circular.
Conflict and Benefit
One potential benefit of this approach is that is helps to manage the complex relationship between asset managers and their owners. By demanding high ratings, which are supposedly guaranteed by the due diligence of the agencies, the owners can protect themselves against their managers investing in dodgy stuff, like self-certified sub-prime mortgages offered on low introductory interest rates. On the other hand, it has been previously noted that contracting out this kind of regulatory function is a bit odd: why only ratings, rather than allowing the majority of financial regulation to be performed by competing market based companies?
Meanwhile the obvious conflict of the agencies' role in regulating their customers with their reliance on the self-same customers to hit quarterly revenue targets was always a potential problem, but oddly enough didn't turn into a real one. The reason for this, it seems, was that up until the turn of the century this wasn’t really an issue because no single client accounted for as much as 1% of the revenues of the agencies and so none of them were able to exert any undue influence. It was only when the rating of structured financial products started to dominate the agency’s business at the beginning of the new century that the problems appear to have started.
Customers (Deceased)
As John C. Coffee, Jr. relates in Ratings Reform: The Good, The Bad and The Ugly:
“The top six underwriters … controlled over 50% of this market, and the top dozen accounted for over 80%. As a result, they possessed the ability to threaten credibly that they would take their business elsewhere – a threat that the rating agencies had not previously experienced”.Top of the list were a couple of institutions you may vaguely remember: Lehman Brothers (decreased) and Bear Sterns & Co (also deceased). At the same time the ratings duopoly of Moodys and S&P was under threat from Fitch. As Becker and Milbourn suggest, the additional competition didn't lead to improvements in ratings quality:
“We find three pieces of evidence, all consistent with a reduction in credit rating quality as Fitch increased its market presence across industries. First competition is associated with friendlier ratings (i.e., they are closer to the higher rating AAA). Second, ratings and bond yields have become less correlated … Third, at least in the short run, equity prices react more to downgrades as competition increases, consistent with a lowering of the bar for ratings categories”.Quite marvellously, more competition seems to have led to a race to the bottom: a classic market failure condition. Of course, this may be the inevitable result of an unexpected challenge to an industry with historically high barriers to entry: it’s no surprise that Warren Buffett invested in Moodys, as it’s a classic moated stock.
Market Failure or Not?
While the ratings agencies were largely immune to competition and client pressure their function as a de-facto part of the regulatory system seems to have worked quite well. As usual in finance, if something works for a while everyone assumes it'll work forever, even if the environment changes. When the agencies' immunity was destroyed the fact that there was no one to regulate them was pure poison for the global economy. The ratings agencies turned out to be about as close to a single point of failure for the whole system as you could possibly imagine.
Obviously governments and regulators have now woken up to the risks posed by the CRAs and are furiously figuring out how to close the various stable doors while looking around for some horses to place behind them. The Coffee paper describes the various manoeuvrings in this area, and how these differ between jurisdictions.
Overall it’s not really clear as to whether this was a genuine market failure – and therefore inevitable – or a consequence of the behaviour of the managements of the rating agencies under competitive pressure, such that events could have transpired differently. The suspicion is a bit of both, but it does rather leave open the issue as to whether regulatory functions can ever be effectively outsourced.
Related articles: Complexity in Financial Systems, Going Dutch, The Benefits of Sound Money, It's Not Different This Time
Another aspect is that as public companies (S&P & Moodys) they were in a revenue generating mode. That gave companies the opportunity to "shop"for the highest rating. And while they were in this mode, the agencies were incentvised to offer more services. The result was that quality suffered.
ReplyDeleteAs a user of the Agencies' offerings, we knew what there models were and pretty well how they came to their ratings. Thus there was considerable transparency about what they did. It was pretty much a case of caveat emptor
This is an important critique of the ratings business and sadly one which is probably not getting as much attention as it deserves.
ReplyDeleteRemoving any and all SEC and regulatory reference to ratings would help to shrink the influence of the ratings scam.
The ratings agencies are "security theater" for the world of finance.
I blame the regulators more, because they were the ones that required rating for their risk-based capital models. Take that away, and the need for ratings declines.
ReplyDeleteThen again, there are few simple or good solutions for credit risk allocation away from using ratings.
http://alephblog.com/2010/04/23/in-defense-of-the-rating-agencies-%e2%80%93-v-summary-and-hopefully-final/
Trouble is, there is always mischief that can occur in multiparty economic deals. Usually the player with the most information tries to co-opt some neutral players, to the disadvantage of information-deficient players, who are often offered an above market yield for their troubles.