Financial Economists Roundtable Weigh in on NRSROs

Recently the Financial Economists Roundtable (FER) posted a summary of their thinking in July 2008 on Reforming the Role of Statistical Rating Organizations [SROs] in the Securitization Process. The FER is a group of senior financial economists who advance the study of finance and frame current policy debates. I read their statement in the Dec. 2 issue of RGE Monitor. SROs, aka NRSROs, are SEC designated credit rating agencies.

Like the SEC reform proposal released about the same time, the FER statement inspired no comments of passion or controversy. That is a shame, because unlike the SEC proposal, the FER statement comes close to the heart of the matter and deserves a thoughtful response, or at the very least some controversy. So, from the practitioner’s view, let me play devil’s advocate.

FER’s key conclusions are that they—

  1. …support strategies designed to improve SRO incentives by increasing the transparency of their modeling practices and holding their managements accountable for negligent ratings errors.
  2. …challenge the wisdom of incorporating SRO ratings in securities and banking regulations issued by governmental entities.
  3. …recommend SROs publish an express margin for error in their ratings for every tranche of securitized instruments, to acknowledge differences in the degree of leverage that is imbedded in different issues of securitized debt.

My reading of these points is as follows—

The first bullet (1) implies that merely looking at NRSRO models and approaches would tell us what went wrong. That’s unlikely to be true. In the past (more than now) rating agencies historically disclosed a lot about their models, and there were flaws, but self-correction did not arise from the disclosure. Rather, the market believed in their magic all the more fervently because they saw how the power of the NRSRO could overrule logic.

R&R focuses the problem differently. The lack of opportunity to study structured ratings in a formal setting contributes to the problem more subtly and profoundly than any other single factor. What is primarily needed is not more transparency but basic structured finance literacy.

To be blunt, none of the 27 FER signatories are affiliated with universities where structured finance/securitization is taught, or taught in a way that remotely corresponds to market practice. Nor is there an attempt to integrate such content into courses dealing with (i) money and banking, (ii) traditional corporate finance, (iii) portfolio analysis, or (iv) options. My remark in regards to (iv) may sound excessively harsh, since many of the affiliated universities offer credit derivatives in their curriculum as an extension of option theory. Nevertheless, there is no opportunity for formal study and critique of the underlying cash analytic framework that gives rise to ratings on structured tranches in the first place. The reason, quite simply, is the lack of academic expertise in this area. My comments, which relate to the finance curriculum in business schools, also apply to accounting.

How can we talk about elevating the standards of analysis and raising the accountability of SROs when we do not enable our MBAs to understand and follow the paradigm shifts taking place right under our noses?

(In the interest of full disclosure, fewer than ten people in the world teach real-world securitization. Sylvain Raynes and I are at least one-fifth of that population. Does my comment signify preaching for my own parish? Or does it make me somewhat uniquely qualified to raise these points?)

(2) is a good idea. Like most market professionals, R&R principals are skeptical about government-mandated solutions for the market — most of all when they are government-mandated commercial solutions. For point (2), however, separating SROs from a quasi-regulatory role implies a capacity for self-regulation. Taking self-regulation to the limit, recommendations (1) and (3) would no longer be relevant, because the SROs would no longer matter much. The underpinnings of self-regulation lead us back to the primacy of education and training raised above (1).

But, more needs to be said about reversing the role of an institution (the SRO) that has been around for 2008-1936 = 72 years. That was two decades prior to the rise of modern accounting in the 1950s. Securitization accounting is another instance of a failed system. The frank discussion of obstacles to creating a reporting language for structured finance/securitization activities without undermining the tenets of the accounting paradigm in FASB 140, Appendix B makes for enlightening reading.*

Taking the idea of disclosure-based regulation to the limit, is America prepared to become the information society we would need to become in order to free ourselves from relying on designated authorities who tell us what to think? Are we prepared to shoulder responsibility for the decisions we make for ourselves, psychologically? financially? Yet, if finance is not prepared to become bold or knowledgeable enough to govern itself, why should it deserve a free market?

(3) is where the proverbial rubber meets the road in financial theory. Credit volatility is a property of the underlying cash flows that form the credit structure of structured securities. With the passage of time, this volatility changes in a pattern that is time- and structure-dependent. Quantifying how the credit exposure improves or deteriorates is the essence of the valuation problem.

In one sense, calling credit volatility an error term shows an essential misconception about the value proposition of structured securities. But in another sense, the FER are due an enormous amount of credit for having hit the nail on the head, albeit from the canon of corporate securities valuation and stochastic calculus. Because credit volatility is real and not a result of modeling error, imposing the assumption of constant returns (static ratings) on structured securities introduces pricing errors precisely by imposing an exogenous (and incorrect) assumption about the distribution of structured risk.

Once again, in the interest of full disclosure, the commercial premise of R&R Consulting is the need for dynamic risk analysis in structured finance/securitization. We were pioneers in describing the non-stationary nature of structured risk and modeling it for the cash market.** Does that mean we’re “selling snake oil”? Or does it make us unusually well qualified to identify the central valuation arguments and debate them?

Other comments about the role and function of rating agencies in structured finance that can be found in the paper are important and worthy of counter-comment. I leave those for a follow-on blog.

— Ann Rutledge

*Yet, despite its shortcomings, GAAP is much closer to practical reality than IFRS. As we contemplate abandoning GAAP in favor of the European system, should we not reflect on the adverse consequences that shift would have on reviving the securitization market?

**Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford University Press, 2003, pp. 101-103.