Arnold Kling  

The Security Rating Game

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Joshua D. Coval, Jakob W. Jurek, and Erik Stafford write,


First, the securities' credit ratings provided a downward biased view of their actual default risks, since they were based on the credit ratings agencies' naïve extrapolation of the favorable economic conditions. Second, the yields failed to account for the extreme exposure of structured products to declines in aggregate economic conditions (i.e. systematic risk). The spuriously low yields on senior claims, in turn, allowed the holders of remaining claims to be overcompensated, incentivizing market participants to hold the "toxic" junior tranches. As a result of this mispricing, demand for structured claims of all seniorities grew explosively. The banks were eager to play along, collecting handsome fees for origination and structuring. Ultimately, the growing demand for the underlying collateral assets lead to an unprecedented reduction in the borrowing costs for homeowners and corporations alike, fueling the real estate bubble...

In March 2007, First Pacific Advisors discovered that Fitch used a model that assumed constantly appreciating home prices, ignoring the possibility that they could fall.

The authors then quote a transcript of a phone conversation between First Pacific and Fitch that makes the latter (one of the credit rating agencies) appear to be idiots. The authors continue,

It certainly appears that rating agencies did not fully appreciate the fragility of their estimates or the possible effects of modest errors in assumptions about default correlations and probabilities in their credit ratings. But this lack of understanding was apparently shared by the regulators that tied bank capital requirements to ratings, as well as by the investors who outsourced their due diligence to rating agencies without sufficient consideration of whether credit ratings meant the same thing for structured finance as they had for single-name securities.
[emphasis added]

So we have the suits vs. geeks divided, and the problem of regulatory capital requirements, both of which I have been emphasizing.

Thanks to Tyler Cowen for the pointer. I strongly recommend reading the whole paper.


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COMMENTS (6 to date)
English Professor writes:

To me, as a non-economist, the failure of the ratings agencies has been the most shocking aspect of the current crisis. I can understand people taking risks by buying on leverage; I can understand the professional investor's getting caught up in what turns out to be a bubble; but I always assumed that the ratings agencies were a disinterested party devoted solely to risk management and thus always on the alert for unrecognized or unacknowledged risk. Boy, was I naive!

http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html?partner=permalink&exprod=permalink

Above is the link to a New York Times article called "Triple A Failure" by Roger Lowenstein.

Lowenstein traces an issuance of mortgage backed securities and watches the way it runs through the pile.

It is also interesting to note the history of the credit ratings agencies and why the SEC gave them the government charter in the 1970s. The government regulation in place hadn't really changed since then, but the real world had.

I think that the credit rating agencies are at the heart of the current crisis. If I mananaged a portfolio for a bank or an insurance company, I would pay attention to the AAA rating for industrial grade investment securities.

By gaining that rating investment banks were able to sell them in mass, and central banks and institutional holders of debt snapped them up. This cleared the market, and allowed the bundlers of these MBS to go back and by up more and bundle them up. It kept the process running, and fly by night mortgage companies could keep giving anyone a mortgage as long as they could sell it to the bundlers.

The failure of these agencies to assess risk (and the public's trust in them) is at the heart of the entire crisis.

[Link modified. Please note: If you are going to post links to online sources such as the NYTimes, please find their permanent links. You can find usually find permanent links in the sidebars, under Share, or at page bottoms. Do not post links to your personal login page.--Econlib Ed.]

DWAnderson writes:

I agree. I find the failure of the ratings agencies to be pretty hard to explain. As private market actors unconstrained by regulatory dictates on how they did ratings, I would have thought that a more sophisticated system for rating risk would have evolved. Apparently it did not and the ratings agencies were effectively captured by the rated entities.

I would have thought that such capture would have seriously degraded their value to the market-- perhaps being used only to check a box with respect to a rating required by other financial regualtors (e.g., with respect to assets held by a bank). However, from what I have read unregulated investors actually relied on the substance of the ratings.

Why they did so in the face of evidence of capture is mysterious-- do we just chalk it up to a bubble mentality?

Reprinted here.

Methinks writes:

As a former equity analyst, I can completely understand how ratings agencies used these assumptions. Steady growth rate assumptions are easy and sensitivity analysis can be nuanced - too much work. What I don't understand is how sophisticated investors (and mom & pop are not the ones buying structured financial products) didn't bother asking about the assumptions used by credit rating agencies.

I think they may have been lulled into the belief that since these are government approved agencies and the government tends to be conservative, they used a conservative ratings methodology. Regulators can't understand most of the industry they regulate. They're outclassed and a lot of people in the industry don't realize this. A false sense of stability is the result.

Steve Roth writes:

>suits vs. geeks divided, and the problem of regulatory capital requirements, both of which I have been emphasizing.

Both true. But the title of your post, and what you quoted, is mostly not about those things, but about ratings agencies. Which you've pooh-poohed as immaterial and trivial.

It really seems like that might stem from not wanting to say that any regulation of private enterprise, of any kind, could have had or might in the future have any merit. (Yes, you suggested retrospective curbs on frannie, but that is/was a gov't op, implicit or otherwise.)

Which in turn smacks loudly of the "market fundamentalism" that Bryan goes to such lengths in his book to demonstrate doesn't actually exist.

Les writes:

I think it is naive to regard the rating agencies as naive. They have powerful incentives to be slow to downrate securities.

First, they are paid by the organizations whose securities they rate - so they are naturally reluctant to bite the hand that feeds them.

Second, they are an oligopoly, and very reluctant to do anything extreme that would threaten their comfortable equilibrium - such as breaking out of the pack.

Third, downrating a security tends to be a self-fulfilling prophecy, because it could be a kiss of death (or at least a kiss of serious injury) to the organization being downrated. A timely downrating would perhaps would lead to being sued by the injured party. Safer to be too late rather than too early to downrate.

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