Rating the Rating Agencies and Securitization
by Michael S. Rozeff
by Michael S. Rozeff
Structured finance and securitization have blown up in the Panic of 2008. Those in power have learned nothing about the current economic catastrophe. The U.S. government is still supporting Fannie Mae and Freddie Mac and still trying to resurrect a system that has collapsed before its eyes.
There is little question that governments here and abroad provided the major impetus for these financial methods that have come to grief. In his book, Securitization, Vinod Kothari writes: "In most countries, governments have tried to promote housing finance, by setting up specialized housing refinance bodies or secondary mortgage market bodies. The largest housing finance institution in the world, the Government Housing Loan Corporation of Japan, is a government-owned entity. The largest housing finance body in the U.S., Fannie Mae, is a government-sponsored entity. There are housing finance bodies of different descriptions throughout the world that are promoted, owned or supported by governments such as Hong Kong, Malaysia, India, France, South Korea and Spain." Kothari's description can be believed, for he is not a critic of these practices. He believes that "governments owe it to their citizens to promote affordable housing."
It would be a grave error to blame the Panic of 2008 on rating agencies. But because the ratings seem to be at the center of the vortex, we need to consider them. Major players in the financial community to a great extent got caught up in a larger tide or wave that was beyond their control. They work within a system. That system, in this case, involved government and banking system support for housing finance and a government and central bank going to great lengths to prevent or mitigate recessions. But, at the same time, the financial players contributed to the tide of events. Government provided the picture frame, the support, and the materials. Following the lure of profit, the financial industry was induced to paint the government-desired portrait.
The government now has many convenient fall guys. It's even bailing them out. The public does not see that behind the curtain, the government pulled and is still pulling the levers.
In their 1969 article "What's in a bond rating?", Thomas Pogue and Robert Soldofsky showed that one could, on one's own, largely replicate the bond ratings produced by bond-rating agencies. The statistics available to do the rating were available to the public. Do-it-yourself ratings were feasible.
In 1977, Mark Weinstein showed that the bond market anticipated ratings changes made by the rating agencies. If a bond was going to be downgraded, the market price had already substantially dropped by the time the ratings change was announced. Investors in the market effectively did their own rating changes. The rating agencies developed some information about securities that other investors did not have, but investors also were able to assess the risks of debt without the rating agencies.
Weinstein's findings stand to reason. Investors assess a continual stream of information that alerts them to changes in credit-worthiness. They have a very large profit incentive to assess and continually re-assess the risk of debt instruments in case the market and the rating agencies have it wrong. Investors still have access to information and they still have a profit incentive, so that they still do their own rating changes in the market; the markets marked down many, many debt instruments in 2007, well before the rating agencies downgraded them.
In the 60s and 70s, debt instruments were simple. The rating agencies hardly ever went wrong. The rating agencies sold subscriptions, which means their ratings had some value. They did not sell ratings to the issuers of debts. But starting in the 1970s, they changed their business model. They began charging issuers for ratings. (See here.) They began working ever more closely with the issuers. The issuers structured securities so as to obtain the desired ratings. In addition, structured finance securities became the fastest-growing and most highly profitable part of the ratings business, providing half the revenues. A greater potential for conflict of interest arose. It is not hard to imagine that the technicians at the rating agencies, who have similar training to the technicians working for the investment bankers, would share the same outlooks and assumptions about risk and the evaluation of risk. It is not hard to imagine that they would develop working relationships that would paper over the very real difficulties in evaluating the loans and the options packaged up into exceedingly complex securities.
The securities being rated and issued and the ratings process became far, far more complex. (See here.) Evaluating the many loans packaged into each deal required a very high level of technical expertise and time. These securities contained embedded options whose pricing and risk were open to ambiguities and uncertainties that the mathematics glossed over. Many investors, usually institutions like pension funds and mutual funds, lacked the time and expertise. Yet they wanted to invest in the securities because they promised greater returns for the risk, or so it seemed at the time.
The demand for ratings arises in part because governments regulate the investments of banks. For example, the California code has "eligible securities" that must have an "eligible rating" by an "eligible rating service" (see p. 100 of the code). The regulators choose the major ratings firms as eligible. The demand also arises because institutions like mutual funds and pension funds are regulated fiduciaries and need some kind of legal cover for the investments they choose to make. The major rating agencies fill the bill because they are a government-approved cartel. In 1975, the SEC created a designation for credit-raters: Nationally Recognized Statistical Rating Organization (NRSRO). The SEC rule created a cartel of three firms: Standard & Poor's Credit Market Services, Moody's Investors Service, and Fitch, Inc. — these being the only firms that qualified for use by broker-dealers for satisfying another of the SEC's rules on net capital. This topic is covered here.
With more research, we may find issues and problems with the major rating agencies, that show that the cartel brought about a degree of laziness and ineptitude in assigning ratings. We may pinpoint conflicts of interest. Various court cases will shed light on the internal workings of the structured finance process. However, since the market accepted the debt ratings and can re-rate debt on its own in the market place, there are likely to be other reasons why the ratings of securitized debts proved to be wide of the mark and contributed to the Panic of 2008. Why did the market and the rating agencies both price certain credits as if they were very sound when, in a short time, they turned out to be quite unsound? Why were, what we now know to be bad debts, not foreseen? Even though government and the Fed engineered over-investment in housing and a housing price bubble, we still have to wonder why investors and the rating agencies cooperated with the bubble, participated in it, and supported it with high prices and ratings for securities that turned into junk. In some sense, their being fooled or induced into participation is what defines a bubble. I believe that rising prices and profits encourage participation. Behind those lie the government-sponsored enterprises. Fannie Mae and Freddie Mac sopped up huge amounts of securitized mortgage loans. They supported the market. That "success" encouraged securitized loans for commercial real estate, consumer loans, credit card debt, and other loans that are now also coming a cropper as the bubble pricing structure collapses across the board.
We need to think about investors and rating agencies separately. Investors buy these securities, but investors are not uniform. The bulls buy from the bears who sell. In 2007, the bears turned out to be the smart money; the bulls were the dumb money. The Wall Street Journal carried a story about a smart-money man, named William Graham, who manages a hedge fund. He bought credit insurance on a complex debt security called a CDO. When the CDO market fell, the value of his insurance rose because he could get the full insured value. The seller, who wrote that insurance, was the dumb-money man. His name was Alan McCormack. He sold the insurance on behalf of a county in Australia. The county now has to make good on the insurance it sold.
Why did Graham and McCormack take the opposite sides in this trade? We have a part of the answer. A local bank recommended the purchase to McCormack. The security promised 1.2 percent above a bank rate. It was rated AA. The companies collected within the securitized investment were thought to be sound. They were not. They included such eventual failures as Lehman Brothers, Washington Mutual, Freddie Mac, and two of Iceland's banks. McCormack didn't see the crash coming, the same crash that he was providing insurance against. McCormack was actually writing a naked put option, which is a risky and exotic technique. The premium he was charging was nowhere near high enough to cover the risk. Graham knew that. What he saw was that he could turn a risky CDO into a riskless CDO by buying rather cheap insurance.
Graham and McCormack were separated by a number of intermediaries who brokered. But, for all practical purposes, they traded with each other. The first thing to realize about investing is that when you are buying, someone else is selling. And that "someone else" may know more than you do.
The AA rating played a part in persuading McCormack to buy. But we can't blame the rating agencies entirely for their over-ratings because investors like McCormack do not have to accept those ratings when they buy and sell debt securities. Unlike the old days, they cannot form their own independent assessments because they lack the information that is available to the rating agencies. They are buying a pig in a poke. They are foolishly buying without a close examination. Instead they are relying on the ratings and their bank's recommendation with some mixture of their own greed for higher return. Those like McCormack that trusted will not be so trusting in the future. Once burnt, twice shy.
The AA rating for this security was, nonetheless, a blunder. Indeed, the rating agencies blundered big time. How did that come about? While conflicts of interest and seeking of profits may have played a part, I believe that the main reason was bad estimation of models. The rating agencies made bad judgments concerning the risks of the securities. They relied on historical data and thought that the future would be like the past. They looked at matters narrowly. They did not see that an economy-wide tower of debt would not reach to the sky. This blind spot about debt is pervasive. Today, faced with the collapse of that tower, governments and central banks worldwide are again trying to rebuild it.
The new days for debts began in the mid-80s. Many of the new debts that have fallen so much in price and caused such big losses are complex, not simple, securities. They are created from collections of loans and securities which are then divided into sub-categories called tranches. The first ones I ever heard of were around 1986 at a finance conference. They are called collateralized mortgage obligations (CMOs). At the time, they repelled me. What foolishness is this was my reaction? Who is fool enough to dabble in these non-transparent and illiquid vehicles with complicated pricing? I have my investing biases, which include high risk-aversion. I am repelled by complex investments whose pricing I cannot understand or whose underpinnings depend on imponderable variables. I am repelled by illiquid investments that cannot be easily sold. I am repelled by investments devised by mathematicians and sold by investment bankers. They probably know more than I do. I am likely to be the loser. I am repelled by hidden risks. How can I expect to get a good deal with all these reservations? Other such illiquid and doctored up investments include the limited real estate partnerships that came along some 20—30 years ago. I remember a prospectus running 150 pages of fine print. But what seems like common sense to me I have learned is not always common sense to others who are more willing to take chances.
The pricing of the CMOs had definite weak spots. Pricing them required the ability to uncover and price embedded and complicated options. Mortgage borrowers could prepay their mortgages; they had an option to prepay. No one knew exactly how to estimate prepayment. Prepayment changed the duration of the security in ways unlike the usual bond duration. These bonds tended to fall faster in bear markets than they rose in bull markets because of their "negative convexity." The various tranches differed in these qualities.
The rating agencies had to rate these complex instruments. They hired more or less the same kinds of people who created them in the first place. Everyone made more or less the same assumptions, based on past history, about prepayment risks. The rating agencies did no worse than anyone else. It seemed to be good enough. There were no immediate blowups. The years came and the years went. Confidence in these instruments grew. Besides, the government and the Fed always seemed to be there to get the economy going again when it slowed down. Recessions were mild. New Era thinking began to flourish.
Investors wanted these securities. That is the other side of this story. Wall Street manufactured and distributed these securities to institutional investors. They provided the kinds of returns and risks that these investors were looking for; they wanted a little extra bang for the buck. They wanted to look good so as to attract the money of individual investors. Clearly, the little guy has a problem in assessing the risks that are being taken by the big guys he turns his money over to.
We digress into another problem area in our financial system. The institutions who buy these securities often do not adequately check up on the risk of them. They accept the S&P ratings and go for the higher yields. Why? It's too costly to evaluate each issue. The issues seem to work. Their investors don't seem to care. They are in competition for funds. Furthermore, they may accept the ratings if buying in certain rating classes has been legislated to cover their rear-ends. The institutions doing the buying are often government funds and pension plans, banks, mutual funds, hedge funds, etc. They are institutions, not usually individuals. They are agents of individuals, and being such they do not exercise the care that individuals would exercise, especially when the individuals are a captive group. Individuals often do not or cannot check up on the institutions doing the investment for them. If you are a policeman who works for a town in Maine that is on the Maine retirement system, your investment choices are restricted. Restricted investments are often the case. The system of investing through these agents lacks the appropriate checks and balances of a market system. It is highly paternal. It discourages people from learning how to invest on their own. It discourages them from learning about risk. What's more, the people doing the investment may farm it out to yet other managers so that there is even another agent layer.
The ultimate bag-holders are the working stiffs who are the contributors to these plans. They often have no choice, so that the system is not as free as it looks. These plans that use agents are brought about through tax loopholes (such as IRA plans) that don't encourage individual management of one's investments. In many cases, the person has to leave the money with the plan managers.
The institutions are the ones who ratify the ratings of the rating agencies by buying the securities. The contributors have little or no idea what their portfolios are being stuffed with. If they knew they contained exotic securities or were loaded up with the debts of banks, would they be buying those investments on their own? I certainly would not like to turn over thousands of dollars to unknown agents following unknown strategies.
There are some fine institutional money managers who do a service. They write to me when I plump for people to learn how to manage their own investments. I expect to hear from them again. If the average person does not want to manage his own investments, he still has a nontrivial problem, which is the evaluation of the managers. End of digression.
The finance profession (the professors in conjunction with financial engineers from math and physics) extended their option-pricing models. In this was much profit. Professors crowded into Wall Street. They multiplied the number of complex securities into a veritable alphabet soup. To price the securities, they had to measure certain parameters. They had to make certain assumptions. They tended to look at past history. It is at this point that bad estimations creep in. It is at this point that the rating agencies are likely to make bad assumptions about risk. The basic error is in thinking that risk is measurable using past statistical data that is limited in scope. The weak spot in the thinking of the financial engineers and of modern finance is the presumption that they understand risk and can measure risk. There is overconfidence in this realm. Finance professionals are bewitched by numbers, complex mathematics, and elegant models. They think they can measure risk objectively. This is why they are surprised when a seemingly rare event occurs that they think shouldn't have happened in 10 million years.
Beyond the estimation issue, there is an issue of modeling. Most models of complex securities use various stochastic processes that are complex but mathematically tractable. Yet the actual processes that generate returns are even more complex and not reducible to a process that can be modeled. I very much doubt that economists of any school, despite their pretensions, understand the factors that determine price levels of goods, but those prices are critical inputs to the returns that securities generate.
The bubble game played out quite rapidly between 2000 and 2007. Before then, the ratings on these complex instruments held up. The investment bankers went for the gold and began cooperating with the banks and mortgage brokers who originated the mortgages. They fundamentally altered the banking model. They packaged up mortgages into packages that the raters were asked to rate. The regulators encouraged this change in the nature of the banking business model. They didn't see that the banks had a weaker incentive to create strong mortgage loans (because they were selling them off) and a stronger incentive to pass on their worst mortgages to others. Greenspan publicly praised the whole process of securitization. He encouraged mortgage re-financing as well. This was a major leadership error coming from the top, and it helped propel the system into a frenzy of securitization. Greenspan thought that the risks were being managed and appraised in excellent fashion. But the model estimates were flaky and the institutions taking up these securities probably did not exercise the care and diligence they would have if they were investing their own money.
The whole story of the Panic of 2008 is complex. The basic causation traces largely to government, but it does not lie solely with regulation or inept deregulation. People in free markets make mistakes. They adopt business models that fail. Failures are an inherent part of free markets. But government attempts at protecting people from failures are worse than the failures themselves. The free market, or some semblance of it, was induced to try an experiment with securitization and it blew up. That happens. Even in entirely free markets, people will blunder and have to learn. The free market is not a panacea for human ignorance and suffering. Then again, neither is government. People learn even less quickly and remain in even greater ignorance when they turn their affairs over to government to manage. There is no more unresponsive agent than government and none that has a lower incentive to satisfy the demands of the people who turn to it and trust it to solve their problems.
The risks and drawbacks of securitization were ignored in the flush of a success that was supported by government and government-sponsored enterprises. Securitization is all but dead, but it's on extremely expensive life support being paid for by forced exactions from taxpayers.
December 26, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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