FinReg for dummies: the ratings agencies

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[Image source: Tom Toles at Washington Post]

Well, seeing as how the Senate has passed the financial regulation bill, I’ll have to have to continue the FinReg for Dummies series in the context of the bill as it exists.  It won’t change too much, but I guess it means I have to get to it.  Next stop: the ratings agencies.

Ratings agencies are private companies that are credentialed by the federal government to rate the risk of financial investments, such as stocks, bonds and derivatives.  The three major ones are Standard and Poor’s, Moody’s and Fitch.

There are two primary reasons ratings agencies exist.  First, they allow investors who don’t have time to investigate the risk of an investment to have a standardized rating to work off of.  Second, they allow for the establishment of minimum standards to be applied to certain activities.  For example, banks are allowed to take on more debt if they hold a proportionate amount of AAA-rated securities.  Another important example is that more conservative investors, such as pension funds, are legally prohibited from investing in assets that haven’t received a minimum acceptable rating.

There is an argument to be made that the existence of ratings agencies is fundamentally problematic.  If banks and investors do not have to do their own due diligence, then they cannot never truly understand risk of their investments.  And this is exactly what happened.  Banks took any investment that was shrink-wrapped and stamped with a AAA rating, and were thus able to do it with borrowed capital.  It was many of these AAA rated securities, which are supposed to be as safe as U.S. treasury notes, that went sour and caused some banks to collapse.

Thus the role that the ratings agencies played in the financial crisis cannot be understated.  Since investors could not assess the risk of every single mortgage issued, they were packaged together into securities whose overall risk was supposed to be analyzed by the ratings agencies.  So how did we get to a point where investments that were obviously risky – i.e. mortgages given to people who couldn’t afford them – were getting blessed with the highest ratings?

The answer is two-fold.  The first answer is related to the statements you hear about how mortgages were sliced-and-diced into a million pieces.  Here’s how it works: a group of mortgages gets packaged together into a single investment, with the stream of interest payments paying out to the investors.  Within the investment, the mortgages are broken into three risk groups, called tranches.  The least risky investments received AAA ratings, which helped to conceal some of the risk found in the lower tranches.

But the ratings agencies should have seen which assets were being dominated by riskier mortgages, which brings us to the second reason they failed.  The ratings agencies were set up in a fundamental conflict of interest.  They were paid by banks issuing the investments, and the banks were free to shop around for different ratings from different agencies.  Ezra clarifies the absurdity of this:

Imagine a school with three teachers. But this isn’t a public school. It’s a private school testing out an innovative new funding system: The kids write the tests, fill them out and then pay the teachers to grade them. If they don’t like the grade they get, they don’t have to go back to that teacher.

You can imagine how this plays out.  If a bank doesn’t like the rating it gets from one agency, it just moves on to the next until it finds the one that gives it an acceptable rating.  The agencies thus had a profit-driven incentive to rate investments higher.  This reality was confirmed by internal documents at Standard & Poor’s that discussed revising their ratings in response to the threat of losing business.  Crisis seeds planted.

Thanks in large part to Al Franken, the financial regulation bill attempts to fix this.  Instead of letting banks shop around for ratings, the SEC will now randomly appoint approved ratings agencies to rating assignments.  They will still be paid by the bank, but there is no longer an incentive to inflate ratings to get business.  Instead, as Edmund Andrews explains, they now have an incentive to compete on the accuracy of their ratings.

What a concept.

Posted on May 21st 2010 in news

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