Wednesday, October 15, 2008

Triple-A Failure

Triple-A Failure

Great article by Roger Lowenstein in the New York Times. It talks about the credit rating agencies and their role in mortgage backed securities. I like the way he traces one mortgage backed securities issue through the process.

As someone with substantial ignorance of the entire process I found it to be informative.

It got me thinking about the current call for regulation of the markets, as well as the accusations that Republicans have deregulated the system and are at fault for all this capitalism run amok.

Penn Central collapsed in 1970, and it was the biggest bankruptcy in US History. It was a financial disaster and people wanted answers. How could this happen?

In 1975 the "US Securities & Exchange Commission starts relying on credit ratings issued by nationally recognized statistical rating organizations (NRSROs) in its rule 15c3-1."

The government wanted institutional debt to be rated by government certified rating organizations, like Moody’s, Standard & Poor’s and Fitch. It appears that this has been how institutional debt has been regulated for the past 33 years. It doesn't appear the Republicans or Democrats put substantial changes into the regulation or the certification of the ratings agencies over the course of time.

As the article points out, the regulation may not have changed, but the times sure did. The article gave some great examples of how investment banks game the system, doing just enough to get a AAA rating.

The fact of the matter is that many of these MBS securities should never had a AAA rating. Hindsight is 20-20. When investors saw that AAA rating they thought that it was a safe place to make a return. Central banks across the world swallowed them up, as well as other large financial institutions. If your local bank manager bought some triple A rated securities and then lost his ass it is hard to color him a complete idiot as he was misled. Some of these were obviously horrible investments that were advertised at the highest grade.

Given the high ratings, the MBS sold. This cleared the market and allowed the originating institutions more money to go out and repeat the process because it paid.

I have no idea if government bureaucrats could do any better than professional credit rating agencies. One of the recomendations of the article was to decertify these ratings institutions of their offical government recognition. A case for deregulation in the NY Times?

Whom Can We Rely On?

The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures — they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.

This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, “ahistorical behavorial modes” by homeowners were to blame for the wave of downgrades. She cited S.&P.’s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies’ mathematical formulas look backward while life is lived forward. That is unlikely to change.

I liked the whole article and it had much more than I discussed. I post it here so I can remember it and go back to it, as nobody has ever read or commented in this forum by lil ol me.

It is good to be king though. This is my domain and I make all the rules.

Here is an addition I found on Powerline:

Why were both rating agencies still rating FNMA and FHLMC AAA? National politics. A downgrade of the two "government sponsored enterprises" to BB (which the average behavior of the rating agencies would have dictated) might have--after the fact--been argued to be the "cause" of their failure, sure to be condemned by the CEOs of both firms and by senior government officials. This rating firms' reluctance to downgrade FNMA's and FHLMC's debt is understandable--no business wants to be singled out for criticism by the government, even if they are correct in their credit assessment.

Beware downgrading government agencies because you will be blamed for the collapse. But Dick Schumer can call out private banks and cause a run, no problem. Sphere: Related Content

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