Thursday, October 2, 2008

Some scrutiny of credit ratings agencies?

In this post which was rather long winded, I had said that the role of credit ratings agencies in the current crisis should deserve some scrutiny. Angry Bear rails:
What is the point of pooling pools of mortgage bonds and making new tranches ? Much money was made by taking the middling seniority tranches of pools of mortgage bonds and reslicing them to make senior (AAA) tranches and equity tranches. Was there really any more diversification to be done ? Or was this a way to game the bond ratings ?

In Reason (ht: Marginal Revolution)
... housing markets being local, so that the assets in the pooled security didn't move together. ... a firm could build highly rated investment portfolios of purportedly uncorrelated assets out of nothing but mortgages from different parts of the country. Once these portfolios were built, it would become easier to finance houses even for buyers of dubious credit. The problem was that these new securities, and the money which flowed into all housing markets, were sufficient to generate correlation in housing values across the country. As everyone followed the experts' advice—and invested in these new mortgage-backed assets—we began to observe correlated behavior in the housing market, nationwide.

So how did the securities maintain their high investment grades? Once correlations were evident, once the interconnectedness of housing markets nationwide was evident, why didn't another set of experts, the rating agencies, step in and downgrade the securities?

Because of incentives, the cornerstone of economists' advice about how to get good economic outcomes. In this case, the incentives weren't there to obtaining unbiased estimates of security values. Instead, incentives favored "rating shopping" and so, unsurprisingly, rating shopping became the norm. The Securities and Exchange Commission's 1994 report, Concept Release:
The Nationally Recognized Statistical Ratings Organization (NRSRO), contained the following sentences:"A mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO." The phrase "one of the two highest rating categories" authorized the firm holding a mortgage backed security to shop for ratings. If one rating agency failed to produce a desirable rating, the firm could look for another, more favorable rating.

Those who made the ratings became like expert witnesses in court, seeing things the way their clients, the firms holding the securities and offering them for sale to you and me, wanted things to be seen. The problem was that shoppers, like a jury, did not have the ability to average out different pieces of testimony to help remove the bias. As long as experts were trusted and the market didn't know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased.

Update (from Angry Bear):
... limit on fees makes it possible for fees to be so low that credit issuers obtain ratings from all reputable agencies. It can also mean that an excellent reputation is not worth more than an average reputation. ... that implicit collusion can be maintained. That is, there is an equilibrium in which both agencies give generous ratings to new instruments and both damage their reputations when the crash comes. ... in this equilibrium, they rate sludge AAA. Then the crash comes and -- so what. They all have roughly equal amounts of egg on their faces. We can't do without credit rating agencies.

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