CRAs: Old Theories In New Papers

Following Moody’s settlement with the Department of Justice in late 2016, two new research pieces by economists and new blogs by ratings experts have come out with warnings that the causes of the financial crisis of 2007 have not been addressed. All have merit. None offers a critical fix.

Alice Rivlin and co-author John Soroushian say rating agency reforms are incomplete and recommend full execution of the Dodd-Frank recommendations. Working from an assumption that CRAs benefit debt capital markets by providing “well-developed tools and experience to assess risks of financial securities,” thereby lowering information costs, they reason the rating agencies were seduced into not using their intellectual capital honestly, and this exacerbated or fueled a coincident housing price problem.

That is the best part of the essay. It correctly specifies cause and effect. Ratings led to housing price inflation, not the other way around as many believe.

But if ratings encapsulate expert knowledge, how did the “experts” get it so wrong in 2007? Insufficient coverage, issuer manipulation and bad data, say the authors. In reality, we don’t know this. What the DOJ found in their cases against Moody’s and S&P is not public information, so here we must trust the authors’ special insights. This is troubling because the authors have no direct knowledge of how ratings are compromised. Meanwhile, those who are genuinely expert cannot evaluate the authors’ claims because they lack the information or are bound by confidentiality agreements not to disclose what they know.

Given the system that we have, the public at least deserves to be provided with concrete evidence that the root cause of crisis really was bad governance and not bad systems. It matters, because quite frankly the bad systems argument is more in line with historical evidence. Also, the recommendations in both the Rivlin and the Lawrence J. White-Howard Esaki papers only serve to strengthen and reinforce the NRSRO oligopoly. Such solutions can only work if the essential problem is one of bad governance.

If the essential problem is more technical, if the anointed NRSROs don’t have the capability to perform their designated functions, and if independent experts have no channel to promote technical improvements, then any recommendation to double down on rating agency behavior, whether by the Olympic Games method or strengthening Dodd-Frank, is just plain perverse. It closes the market further rather than opening it up to competition. We need to see calls for deregulation by Joffe, Pimbley, Harrington, Hu, Crede, Raynes, myself and other experts who are shut out of the inner NRSRO circle in this light.

And we need to consider the problem of system incentives. An entrenched, bureaucratic system not only has no incentive to do the right thing; perhaps more importantly it throws sand in the gears of reform by stifling leadership. Independents aren’t banging their heads against the wall because it will feel good when we stop.

But while I support deregulation from professional self-interest, I doubt it will lead to better ratings. The distribution of power in the capital markets is concentrated among institutions that favor moderately bad ratings because they throw off more low-hanging fruit. That means new market champions are likely to produce no better ratings than the ones we have now. Alas, we can’t have low-hanging fruit without having the whole tree. Efficient debt capital markets require an information layer that can support an entire economy and not just smart, lazy money.

Professionally, I observe that the origin of the crisis was a structured finance rating system too amateurish to assess capital and risk properly. This was always true. All seemed well until risk capital for derivative traders evaporated in the wake of LTCM, and statistical arbitrage traders who understood dynamic risk moved in. They changed the structure of the structured market from a buy-and-hold to a tradable market (with credit derivatives, tradable indices etc.) so they could profit from bad ratings. They had no incentive to uphold market order, and they did not.

Today our capital markets aren’t in bubble mode, but that doesn’t mean the rating agency problem is fixed. More likely it’s the case that statistical arbitrage is not profitable while central bank imposed zero-bound curfews are in effect. And, just because rating agencies are kept busy all year round with SEC inspections and red tape doesn’t mean product quality has improved.

So, if conquering statistical arbitrage was the goal, we have won…for now. But this solution is very expensive. And, the interest rate environment is about to change.