Arnold Kling  

Capital Requirements and Bond Ratings

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Robert Rosenkranz writes,


in effect, the regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating.

Indeed, that is the entire raison d'ĂȘtre of the $6 trillion structured-finance business, which serves little economic function other than as a rating-agency arbitrage. Subprime mortgages (and all manner of other risky loans) held directly by financial institutions are questionable assets with high associated capital charges. Each one alone would deserve a "junk" rating. Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade -- thus turning dross into gold by a sort of ratings alchemy.

Read the whole thing. He recommends using interest rate spreads instead of credit ratings as a proxy for losses. The logic is that the market is likely to be better at assessing risk than the rating agencies.

I think his view has merit. Still, I believe that any attempt to regulate financial institutions using rules and formulas will be gamed. I think that letter-of-law regulation has to be supplemented by spirit-of-law rules. If the CEO's of government-backed institution act in ways that are imprudent even though their actions are within boundaries of regulatory requirements, those CEO's ought to face the risk of imprisonment.


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COMMENTS (10 to date)
caveat bettor writes:

Arnold, back on Oct 24, in a comment I made in response to your "Narratives of Knowledge and Arrogance", I suggested a similar solution to Rosenkrantz's:

An exchange mechanism alone would be weak, but coupled with a clearinghouse requiring dynamic margin deposits and collateralization would reduce the fails risk, as has been true for most other listed derivatives exchanges.

Philo writes:

"I think that letter-of-law regulation has to be supplemented by spirit-of-law rules. If the CEO's of government-backed institution[s] act in ways that are imprudent even though their actions are within boundaries of regulatory requirements, those CEO's ought to face the risk of imprisonment."

This from a libertarian!? "Spirit-of-law" = VAGUE; it amounts to giving arbitrary power to regulators or courts of law. If it were instituted, only the most desperate gambler would agree to be CEO of a government-guaranteed corporation. Why not just admit up front that government guarantees don't work?

Grant writes:

Still, I believe that any attempt to regulate financial institutions using rules and formulas will be gamed. I think that letter-of-law regulation has to be supplemented by spirit-of-law rules.
Do regulators have the sort of knowledge to do this? One would think that only depositors and investors know what their "spirit" is, and you are advocating a completely free market in finance?

Record my vote for what Philo said.

Further, the regulatory requirements are gamed from the start by the congressional regulators.

The House Financial Affairs Committee specifically avoided regulating Fannie and Freddie, even when warned by its requlator OFHEO.

The problem is not gaming the system, it is playing the game as set forth by congressional leaders. They defined the game, and are now "shocked" to see that there were excesses.

I support this further at We Guarantee It

Arnold Kling writes:

From a libertarian perspective, it is hard to have sympathy with government-backed financial institutions. If your deposits are guaranteed by the government, or you have Fannie/Freddie style government backing, you cannot complain about being harshly regulated.

I am not advocating harsh regulation of all financial institutions. And if somebody wants to get rid of government backing, they can make that argument. I am suggesting that government-backed institutions be subject to harsh regulation. Among other things, this would deter aggressive executives from seeking government backing. If you want to be aggressive, do it with private money.

Les writes:

Arnold, you are right to say that "it is hard to have sympathy with government-backed financial institutions."

Apart from the U.S. Treasury and the Fed, why should there be any government financial institutions or government-backed financial institutions at all? Their record of failure is dreadful.

And that includes the SEC, which has not justified its existence at any time, let alone recently.

Craig Bardo writes:

I think Rosenkranz glosses over an important component of the trouble with the regulatory scheme when he says "Rating agencies employ quite ordinary mortals to analyze the credit risk of bonds." Indeed, they have not always been right and have had notable, spectacular failures. But the consequences of this failure are out of proportion and it deserves more than general treatment before it is dismissed as simple regulatory wrongheadedness.

Having represented issuers, he is correct that we designed entire programs based on rating agency arbitrage as well as tax arbitrage for non profit issuers. But why did the ratings agencies get the mortgage securities so wrong and not the hospitals, colleges and universities I represented? Looking at it from the buy side, why were purchasers served better by lower rated health and higher education debt than higher rated mortgage debt?

The answer lies in leverage, not a financial ratio, but political pressure. What power did my issuers have over the rating agencies? Very little. Conversely, how easy would it be for even the most seasoned, hardened analyst to say that the bond that is tacitly backed by the same federal government that effectively provides your charter, is not worth the paper used to print the offering circular? They obviously treated the feds as credit enhancement, looking past the conduit of the GSEs and treating their securities as a full faith and credit obligations.

While I agree with the premise that in the absence of the artificial comfort provided by ratings and regulatory schemes, investors would make better decisions, the role of government as a direct participant can't be overemphasized in the current crisis.

Ruy Diaz writes:

"If the CEO's of government-backed institution act in ways that are imprudent even though their actions are within boundaries of regulatory requirements, those CEO's ought to face the risk of imprisonment."

Even taking into account Arnold's comment in this thread, this is a jaw-dropping statement. Spirit-of-the-law rules is what totalitarian governments do. We should not go down that road (further), even if we dislike government-backed institutions.

Furthermore, a rule like that would create a playground for demagogues. A skilled demagogue--say, a Senator with the skill to demonize--could use the rule to present himself as a savior, and advance his career that way. As insurance for such a possibility, the people taking such jobs would likely be either demagogues themselves, or backed by demagogues; overall, it is a recipe for a worse system than we already have.

Mike Rulle writes:

The rating agencies do bear culpability. However, writers like Mr. Rosenkranz always think errors in judgment are very obvious only after the fact. I would like to know what errors today are as obvious as he says the agencies' were a few years ago. I also do not believe "rating agency arbitrage" is a legitimate concept. As long as some percent of a CDO's assets do not default there is always a possibility to create a AAA instrument. The problem, of course, is someone has to own the subordinated pieces. Who owned these? Largely the the creators of the CDOs themselves, the banks. We know they did not rely on rating agencies but "hedging models".

The problem was intelligent people persuaded themselves that housing prices could not go down. They looked at aggregates rather than the specific underlying collateral. They looked at long term house price trends rather than specific short term behavior by borrowers in specific locations like California, Vegas, Phoenix and Florida. The risk is we will now over regulate the "last problem" while the next "obvious problem" goes undetected.

The rating agencies do bear culpability.

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