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March 27, 2009

Economist's View - 4 new articles

Why Did Ratings Agencies Fail?

The failure of ratings agencies to properly price the risky securities at the heart of the financial crisis has been attributed to conflict of interest (being paid by the issuers of the assets they are rating) and shopping for the best rating (get more than one rating, then only make public the highest one). However, an objection to these explanations is that these incentives have always existed, yet the problems did not emerge until recently. Thus, any explanation relying upon these incentives must explain why they did not cause problems until recently.

This article says the answer can be found in the complexity of the assets that are being rated. When the assets are very simple, risk assessment is not very complicated and the dispersion of ratings across agencies is very low. Thus, there is no incentive to shop around. In addition, it is hard for the agencies to become beholden to asset issuers and inflate ratings because such behavior would be transparent enough so as to risk losing credibility. That is, people outside the agencies can independently check and verify the ratings easily so any manipulation of the ratings would be easy to discover, and the revelation that their ratings are inflated would damage their credibility and hence their business.

But all of this changes when the assets become more complex. First, because of the complexity the dispersion of ratings across agencies will increase. Thus, even if the mean rating does not change, the variance of the ratings make it worthwhile to pay for more than one rating and cherry pick the best of the lot, i.e. to shop around. (In numerical terms, suppose assets are rated from 1, which is the highest risk category, to 10 which is the safest. A non-complex asset might have a dispersion of, say, 7.95 to 8.05 among a fixed number of ratings agencies, while a complex asset might have ratings running from 6.50 to 9.50. In both cases, assuming a symmetric distribution, the mean is 8, but the rewards to shopping around are quite different).

Second, it is easier for the issuer to capture the rating agency, i.e. for the agency to produce the ratings the company is looking for, because the complexity makes such behavior harder to uncover. The ability of outside observers to uncover such behavior diminishes when the variance of the ratings goes up.

To be more precise about the incentive to shop around, there is a cost to obtaining one more rating, the fee the firm must pay (though the article below implies the firm can escape the fee it if doesn't like the rating it gets). The benefit is the chance that the new, incremental rating will be higher than the ratings already in hand, and this diminishes as more ratings are collected, i.e. there is a declining marginal benefit. If the fee is relatively low, it will be worthwhile to collect many ratings, and the expected rating outcome - the maximum of the ratings - will be higher as more ratings are collected. However, issuers do not necessarily collect ratings from every ratings firm since the expected benefit of an additional rating may not cover the cost. But if the fees are sufficiently low, if the assets are sufficiently complex, and if the number of firms is sufficiently small - a case that may describe the recent market fairly well - a corner solution will emerge, i.e. it always pays - in expected terms - to collect all the ratings available and then make only the best rating public.

The other side of this, though, is that the degree of distortion falls when the number of ratings agencies is small. That is, the expected maximum rating is increasing in the number of ratings collected (though the increase comes at a decreasing rate, that's why there is a declining marginal benefit to collecting another rating). It depends upon the nature of the underlying distributions, but it's possible - and I think likely - that the distortion from this factor was low due to the fact that there were only, effectively, Moody and Standard & Poor operating in these markets (do we count Fitch too?). If so, if the shopping around distortion is relatively minor because the number of firms is small (and that is highly speculative on my part, and based upon the quick reactions scribbled out above rather than days of careful thought), then the alternative explanation that the ratings agencies were beholden to asset issuers should be given more weight as the likely, predominant explanation for the problems in these markets.

In any case, here's the article:

The origin of bias in credit ratings, by Vasiliki Skreta and Laura Veldkamp, Most market observers attribute the recent credit crunch to a confluence of factors – excess leverage, opacity, improperly estimated correlation between bundled assets, lax screening by mortgage originators, and market-distorting regulations. Credit rating agencies were supposed to create transparency, provide the basis for risk-management regulation, and discipline mortgage lenders and the creators of structured financial products by rating their assets. Understanding the origins of the crisis requires, at least in part, understanding the failures of the market for ratings. Proposed explanations for ratings bias have broadly fallen into three categories.

It was an honest mistake

New financial instruments were being traded, and rating agencies had no historical return data for these instruments on which to base their risk assessments. These new instruments had a degree of complexity that even financial professionals acknowledged was "far above that of traditional bonds" (Adelson, 2007) and "dizzying" (Zandi 2008). But complexity alone would generate independent errors in ratings, not ratings that were systematically upward-biased and subsequently downgraded in 2008. For this story to make sense, it must be that many raters made the same mistake. For example, they underestimated the correlation of defaults, particularly in residential mortgage-backed securities. This led them to underestimate the risk of a geographically diverse pool of mortgages and to assign such assets inflated ratings.

Agencies were beholden to asset issuers

A host of recent papers explore the conflict of interest that arises when rating agencies' fees are paid by asset issuers. Damiano, Li, and Suen (2008), Bolton, Freixas, and Shapiro (2008), Becker and Milbourn (2008), and Mathis, McAndrews, and Rochet (2008) investigate the extent to which reputation effects can discipline rating agencies who may feel compelled to deliberately inflate their ratings, either to maximise their consulting fees or because the issuer could be shopping for the highest rating.

Asset issuers shopped for ratings

Since, with few exceptions, an asset issuer decides which ratings will be published, he or she can choose to publish only the most favourable rating(s). Former chief of Moody's, Tom McGuire, explains, "The banks pay only if [the ratings agency] delivers the desired rating… If Moody's and a client bank don't see eye-to-eye, the bank can either tweak the numbers or try its luck with a competitor like S&P, a process known as ratings shopping."

Why the trouble emerged recently

While all three of these explanations likely played some role in creating ratings bias, only the first explains why an upward bias appeared recently. Asset issuers have been paying for credit ratings since the 1970s, and, until recently, ratings upgrades were more common than downgrades. Does this mean that the conflict of interest and ratings shopping were not possible sources of the ratings inflation of the last few years and should therefore not be the subject of new regulation?

Our research (Skreta and Veldkamp 2009) looks for a trigger that could explain why the incentive to shop for ratings might have remained dormant until recently. The trigger we identify is an increase in asset complexity. Suppose each rating agency issues an unbiased forecast of an asset's value but asset issuers can shop for ratings. If the announced rating is the maximum of all realised ratings, it will be a biased signal of the asset's true quality. The more ratings differ, the stronger are issuers' incentives to selectively disclose (shop for) ratings.

For simple assets, agencies issue nearly identical forecasts. Asset issuers then disclose all ratings because more information reduces investors' uncertainty and increases the price they are willing to pay for the asset. For complex assets, ratings may differ, creating an incentive to shop for the best rating. There is a threshold level of asset complexity at which shopping becomes optimal and ratings inflation emerges. Furthermore, the link between asset complexity and ratings shopping can work in both directions. An issuer who shops for ratings might want to issue an even more complex asset, to get a broader menu of ratings to choose from. This, in turn, makes shopping even more valuable.

A similar effect might have prompted a recent resurgence in asset issuers pressuring rating agencies to generate favourable ratings. If the guidelines for rating an asset are straightforward and all rating agencies must rate an asset the same way, then there is little pressure an issuer can exert. But if assets become more complex and there are now judgment calls to be made, the agency can legally come to many possible conclusions about what the rating should be. This creates the possibility for conflicts of interest that were previously not present or not so severe. Thus, an increase in asset complexity could have prompted rating shopping by asset issuers and manipulation by ratings agencies. The pattern of downgrades and defaults in the last few years confirms this relationship between asset complexity and over-optimistic ratings – complex CDOs had significantly higher default rates than simple corporate bonds with identical ratings. Similarly, mortgage-backed securities, whose underlying credit risk, correlation risk, and pre-payment risk are notoriously difficult to assess, experienced more widespread downgrades than assets based on other collateral types (Mason and Rosner 2007).2

What does the relationship between asset complexity and the incentives to bias ratings mean for future regulatory efforts? First, the conflict of interest that induces rating agencies to inflate ratings and the ability of asset issuers to shop for the best rating can each independently produce ratings bias. Dealing with one of these problems without addressing the other is unlikely to solve the problem. Second, just because these effects did not produce upward bias in ratings in the 1980s and '90s does not mean that the problems in the rating market structure are harmless. There is good reason to think that such incentives were latent and only emerged when assets were sufficiently complex that regulation was no longer detailed enough to keep them in check. Finally, the ability of ratings manipulation and shopping to affect asset prices only exists when the buyers of assets are unaware of the games being played by the issuer and rating agency. While that was likely the case for some buyers two years ago, today major market participants must have some awareness of the perils of relying on selectively disclosed ratings. If investors mentally discount ratings, then this problem has corrected itself. However, if we forego this opportunity to rethink how ratings are provided, the next bout of financial innovation could trigger another round of ratings inflation and the financial market turmoil that ensues.


1 On 26 January 2008, the New York Times quoted Moody's CEO saying "In hindsight, it is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models." He said that one reason for the failure was that the information quality given to Moody's, both the completeness and veracity, was deteriorating. See also page 10 of the Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit-rating Agencies, United States Securities and Exchange Commission, 8 July 2008.

2 Other collateral types that began to be securitised well after mortgages are far less complex. The first non-mortgage securitisation was equipment leases, followed by credit cards and auto loans, and, more recently, home equity, lease finance, manufactured housing, student loans, and synthetic structures. All of those types of collateral illustrate tranching structures that are measurably simpler than those for RMBS. They had correspondingly lower default rates for similarly-rated assets.


Adelson (2007), Director of structured finance research at Nomura Securities. Testimony before the Committee on Financial Services, US House of Representatives, September 27, 2007.

Becker, Bo and Todd Milbourn, "Reputation and Competition: Evidence from the Credit Rating Industry," 2008. HBS finance working paper 09-051.

Bolton, Patrick, Xavier Freixas, and Joel Shapiro, "The Credit Ratings Game," 2008. NBER Working Paper No. 14712

Damiano, E, H Li, and W Suen, "Credible Ratings," Theoretical Economics, 2008, 3, 325-365.

Mason, Joseph R. and Josh Rosner, "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," 2007. SSRN Working Paper #1027475.

Mathis, Jerome, Jamie Mc Andrews, and Jean Charles Rochet, "Rating the Raters," 2008. Toulouse Working Paper.

Skreta, Vasiliki and Laura Veldkamp, "Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation," 2009. NBER working paper # 14761.

Zandi, Mark (2008) "Financial Shock," FT Press, July 2008.

Paul Krugman: The Market Mystique

What type of financial system should emerge from the crisis?:

The Market Mystique, by Paul Krugman, Commentary, NY Times: On Monday, Lawrence Summers ... responded to criticisms of the Obama administration's plan to subsidize private purchases of toxic assets. "I don't know of any economist," he declared, "who doesn't believe that better functioning capital markets in which assets can be traded are a good idea." ...

Quite a few economists have reconsidered their favorable opinion of capital markets and asset trading in the light of the current crisis. But it has become increasingly clear ... that top officials in the Obama administration are still in the grip of the market mystique. They still believe in the magic of the financial marketplace and in the prowess of the wizards who perform that magic.

The market mystique didn't always rule financial policy. America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. ... And the financial system wasn't just boring. It was also, by today's standards, small. ... It all sounds primitive... Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. ... And finance became anything but boring. It attracted many of our sharpest minds and made a select few immensely rich.

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and pureed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system's juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did. ... Which brings us back to the Obama administration's approach to the financial crisis.

Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so. Beyond that, however, what's striking is the ... administration seems to believe that once investors calm down, securitization — and the business of finance — can resume where it left off a year or two ago.

To be fair, officials are calling for more regulation. ... But the underlying vision remains that of a financial system more or less the same..., albeit somewhat tamed by new rules.

As you can guess, I don't share that vision. I don't think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don't think the Obama administration can bring securitization back to life, and I don't believe it should try.

Fed Watch: The Fed Understands

Tim Duy on the risks to the Fed's independence, and on whether the Fed's insistence that some actions be conducted in secret "damages the democratic process":

The Fed Understands, by Tim Duy: Willem Buiter (via Yves Smith) argues that the Fed's actions over the past eighteen months has placed its independence at risk:

Without a firm guarantee up front that the Federal government will fully re-capitalize the Fed for losses suffered as a result of the Fed's exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

Butier's tone suggests that the Fed is not aware of these risks. But I think the opposite is very much the case - the Fed is agonizing over this issue. See the Fed-Treasury accord that was issued earlier this week; it is a clear effort on the part of the Fed to firmly establish its independence. Note also that some policymakers have made clear their concerns about mixing monetary and fiscal policy. Richmond Fed President Jeffrey Lacker hit on the point this week:

But monetary policy and credit programs do two different things. Monetary policy stabilizes the purchasing power of money over time by keeping the price level stable and relatively predictable, and by doing so, contributes to maximum sustainable economic growth. Credit policy is also aimed at promoting growth, but it is more a form of fiscal policy in that it uses the public sector's balance sheet to alter the allocation of resources. In this instance, credit market interventions have been financed to a large degree by the issue of new monetary liabilities, but they could just as well be financed with non-monetary liabilities, such as U.S. Treasury securities.

Recall that Lacker dissented at the January FOMC meeting on these grounds. San Francisco Fed President Janet Yellen was more clear, reiterating the spirit of the Fed-Treasury accord:

...Critics of the current Fed strategy argue that monetary policy should address only overall credit conditions and should avoid influencing the allocation of credit across particular markets. The joint Treasury-Fed TALF initiative—and even the Fed's purchases of agency debt and mortgage-backed securities—are controversial because arguably they do affect credit allocation.

A second concern is that close policy coordination between the legislative and executive branches of government may compromise the independence of the Fed, and its credibility and commitment to fulfill its dual mandate of price stability and full employment. For example, at some point, monetary policy goals might require a less accommodate stance of policy, even though credit markets might not be fully healed. The Fed might then face political pressure to keep supplying credit to certain markets...

The principle that a central bank, charged with controlling inflation, should be independent from the government is unassailable. It may also be true that it's easier for the central bank to guard its independence from political pressure when it mainly holds government securities.

Lacker to Yellen covers a spectrum from hawk to dove, and it seems neither is entirely pleased with the risks the Fed has taken. Truth be told, does anyone like how this crisis has played out? I believe the Fed made a severe ideological error by choosing to ignore asset and credit bubbles on the theory they could easily clean up the subsequent mess. Policymakers are learning that this is easier said than done. But the damage was done, and policy has turned into an atheists in foxholes situation.

At this point, the best the Fed can do is to set the stage to extricate themselves. For example, note how policymakers will reiterate their intentions to withdraw from financial markets when possible - the Wall Street Journal carried such a story Monday:

Fed Chairman Ben Bernanke told community bankers in Phoenix Friday that the central bank's support would "taper off" once the economy and housing market recover.

"We are very much aware that we don't want to be in the credit markets forever," he said. "We need to help them now, but we want to have an exit strategy, and allow those markets to recover and become again fully private sector."

Yellen hits upon what I think is the greatest risk - that the Fed becomes so entwined in credit markets that they are unable to withdraw liquidity (if, for example, the Dollar plunged or inflation unexpectedly rears up) without undermining particular sectors of the economy, or the credit markets as a whole for that matter. Yellen adds:

As the economy recovers, the Fed will eventually have to reduce the quantity of excess reserves. To some extent, this will occur naturally as markets heal and some programs consequently shrink. It can also be accomplished, in part, through outright asset sales. And finally, several exit strategies may be available that would allow the Fed to tighten monetary policy even as it maintains a large balance sheet to support credit markets. Indeed, the joint Treasury-Fed statement indicated that legislation will be sought to provide such tools. One possibility is that Congress could give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves. Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet.

If the Fed has the power to issue bonds, they could soak up excess liquidity without undermining efforts to support credit markets, severing their reliance on Treasury for financing monetary management.

Butier makes another point on the damaging opaqueness of Fed policy:

The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withhold. The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around $170 billion with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns' balance sheet has been hidden in some SPV in Delaware.

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of taxpayers' resources that it entails threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.

Note that, as evidenced by the Fed-Treasury accord, the Fed is as unhappy as Butier about the Maiden Lane Facility, and wants it off their hands. That point notwithstanding, I think Butier is correct to criticize the Fed for secrecy. If the Fed is going to play in the realm of fiscal policy, their actions should be brought to light. Indeed, I am somewhat concerned that giving any more regulatory authority to an institution with such a culture of secrecy is dangerous. If the Fed expects to have a greater - explicit - regulatory role in the future, I think we must demand a greater level of transparency.

Bottom line: The Fed is well aware that their actions have taken policymakers to a place where no respectable central banker wants to tread. They are clearly worried about the risks to monetary independence from their response to the crisis, and rightfully so. I hope too that they are worried about the precedent that we should accept the Fed as an informational black hole in return for Federal Reserve Chairman Ben Bernanke's commitment to ensure the trains run on time. Butier is right - such a precedent damages the democratic process, and is a high price to pay.

links for 2009-03-27

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