Monday, September 21, 2009

Surowiecki Gets It (Half) Right

In this week's New Yorker, James Surowiecki rightly indicts the three major rating agencies (aka the Nationally Recognized Statistical Rating Organizations) for getting so much wrong by conferring erroneous AAA ratings on "toxic" asset-backed securities, in particular the dreaded mortgage-backed securities that nearly brought down the financial sector:
By giving dubious mortgage-backed securities top ratings, and by dramatically underestimating the risk of default and foreclosure, the agencies played a key role in inflating the housing bubble. If we’re going to reform the system, fixing them should be high on the list.
Yet, the regulatory context that granted their status as nationally recognized is spared from the same harsh criticism he has for the NRSROs:
Rating agencies have been around for a century, and their ratings have been used by regulators since the thirties. But in the seventies the S.E.C. dubbed the three biggest agencies—S. & P., Moody’s, and Fitch—Nationally Recognized Statistical Rating Organizations, effectively making them official arbiters of financial soundness. The decision had a certain logic: it was supposed to make it easier for investors to know that the money in their pension or money-market funds was going into safe and secure investments. But the new regulations also turned the agencies from opinion-givers into indispensable gatekeepers. If you want to sell a corporate bond, or package a bunch of mortgages together into a security, you pretty much need a rating from one of the agencies.
True, but Surowiecki doesn't mention that the regulations, by granting the NRSROs oligopoly status, consequently misaligned their incentive structure. Their ratings held so much weight because competitors were barred from entering the market and offering alternative advice. As the current issue of Critical Review shows, "no competitor could take advantage of [the NRSRO's] mistakes."

Further, as Jeffery Friedman notes in his introduction to the issue:
The net result was that while the three rating “agencies” remained in private hands and could use whatever rating techniques they wished, their financial success did not depend on the ability of these techniques to produce something that somebody would have wanted to buy (in the absence of the earlier S.E.C. regulations)—such as accurate ratings. Instead, their profitability depended on government protection. If the rating agencies used inaccurate rating procedures, they would not suffer for it financially—let alone go out of business.
Worse, many investors were ignorant of the fact that the NRSROs held their hallowed position by regulatory fiat, not because of how good they were at what they did:
One can only speculate about what other methods might have been used by competitors to the rating agencies had it not been for the legal barriers to entry. All one can do by way of example is point to the vibrant market in equities-investment ratings, which includes not only firms such as Morningstar and publications such as Investor’s Business Daily and Forbes, which publish competitive ratings of stocks and mutual funds; but which encompasses many different approaches, ranging from “technical” analysis(which is somewhat akin to historical-probability assessment) to “value” investing (which is somewhat akin to fundamental credit analysis).

Of course, competing bond raters need not necessarily have obtained NRSRO status: Like many equities “raters,” they could have offered their ratings to the investing public for a price. But the price was limited by the investing public’s apparent ignorance of the fact that legal protections, not the accuracy of their predictions, were the basis of the Big Three’s continued existence and profitability. Thus, there was no demand for an alternative. The fact that the bond-rating agencies were shielded from competition is, even now, not widely known among scholars, let alone financial reporters—and such obscure matters are unlikely to be well known to bond investors if they are not reported.
Surowiecki doesn't offer a solution to the problem. He mentions that the idea of "uncoupling the rating agencies from the regulatory system" was a suggested answer, but he fails to mention the reason why: it would have encouraged competition in bond rating. Thus, he throws his hands up and concludes with the obvious:
Oddly, the ratings system, broken as it is, remains attractive to many investors who have been burned by it. For one thing, it provides an easily comprehensible standard: without it, we’d need to come up with new ways of measuring risk. More insidiously, the ratings system provides a ready-made excuse for failure: as long as you’re buying AAA-rated assets, you can say you’re being responsible. After the housing crash, though, we know how illusory those AAA ratings can be. It’s time for investors to face reality: working with a fake safety net is more dangerous than working without any net at all. [Emphasis mine.]
Agreed. But, the best way to find these "new ways of measuring risk" is not from top-down regulation. Instead, we should allow competition to discover the best method. A novel idea.