Via Mark Thoma Economist’s View comes this note on credit rating company incentives:
While the US Department of Justice did not give any statistical evidence in its deposition, our new research (Efing and Hau 2013) suggests that rating favors were indeed systematic and pervasive in the industry.
In a sample of more than 6,500 structured debt ratings produced by Standard & Poor’s, Moody’s and Fitch, we show that ratings are biased in favor of issuer clients that provide the agencies with more rating business. This result points to a powerful conflict of interest, which goes beyond the occasional disagreement among employees.
Additional evidence for rating bias emerges for bank ratings. Hau, Langfield and Marques-Ibanes (2012) show in a paper forthcoming in Economic Policy that rating agencies gave their largest clients also more favorable overall bank credit ratings. …
Hau, Langfield and Marqués-Ibañez (2012) also show that large banks profited most from rating favors. … The rating process for banks may have contributed to substantial competitive distortions in the banking sector, thus fostering the emergence of the too-big-to-fail banks
The lawsuit against Standard & Poor’s highlights the conflicts of interest inherent in the rating business, but can do little to resolve them. If new and complex regulation and supervision of rating agencies provides a remedy is unclear and remains to be seen. However, three alternative policy measures could make the existing conflicts much less pernicious:
- Similar to US bank regulation under the Dodd-Frank act, Basel III should abandon (or at least decrease) its reliance on rating agencies for the determination of bank capital requirements.
- As forcefully argued by Admati, DeMarzo, Hellwig and Pfleiderer (2011), much larger levels of bank equity as required under Basel III could reduce excessive risk-taking incentives and ensure that future failures in bank-asset allocation do not trigger another banking crisis.
- More bank transparency in the form of a full disclosure of all bank asset holdings at the security level would create more informative market prices for bank equity and debt, with positive feedback effects on the quality of bank governance and bank supervision.
Our reliance on bank ratings could thus be greatly reduced. …
“If new and complex regulation and supervision of rating agencies provides a remedy is unclear and remains to be seen.”
The above strikes me as odd, in a cart before the horse kind of way.
Is the issue really that we don’t know if regulation can help, or that more “transparency” and “reserves” are needed or is the real problem the actual product (s) that have been created that might not really be of value to society and thus the economy. That is are these products just junk designed to get ones money and thus should not exist? Are we trying to save the use of stuff that is just so harmful it really is worthless to society and thus the market?
After all, the rating agencies seemed to do just fine until we decided to turn banking into it’s own, stand alone money creating sector of our economy from being a service and thus fully dependent on the production/labor economy for it’s existence.
Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions
Joseph R. Mason
Louisiana State University – Ourso School of Business; University of Pennsylvania – Wharton Financial Institutions Center
Graham Fisher & Co.
May 3, 2007
”We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts.”
Mason and Rosner were slightly ahead of the curve, made sense, well documented but, for most part, ignored.
”What is interesting about these trends is that while as early as January 2005,
delinquency and foreclosure data pointed to substantial deterioration in the
overall credit performance of even fixed-rate prime mortgage loans, actual losses on securitized pools were extremely low during that period. Hence, S&P reported 981 RMBS upgrades and only RMBS 17 downgrades in 2004, and Moody’s reported 414 RMBS upgrades to only 4 RMBS downgrades for the same period. That is the kind of news that led many to believe in decreased market risk.
”In an effort to meet market demands for investment grade assets with higher yields, the rating agencies created new models and approaches to rating these assets. Given the limited number of Nationally Recognized Statistical Rating Agencies (NRSROs) and requirements directing certain investors to purchase only “investment grade” rated assets, their move to rate newer asset classes strengthened their market power,9 or in the words of one rating industry executive, their “partner monopoly”.10 As highlighted by the table below, structured-financial products became a major growth opportunity for the ratings industry and has become an increasing proportion of their revenues….”
The rating agencies were obtaining most of their new business, revenues and profit from those firms creating structured products and very definitely wanted this increase to continue — but they were using incorrect models and overly short time frames [all the better to provide a higher than should be rating in cases at hand].
You can obtain copies from dif. sources, here are two –
The rating agencies were ‘doing just fine’ -because- of their business with structured finance, much of which Required their products be rated,,,,,,hence also more business to the duopoly.
People just haven’t paid enough attention — I posted the Mason and Rosner paper on Roubini’s RGE Monitor shortly after it was published and was told it was not relevant. [Not by Roubini but some self-proclaimed mortgage expert]
Subprime securities – still being downgraded
Some two weeks ago Moody’s announced it was downgrading 28 tranches of various bonds (as well as upgrading two tranches, and confirming others) in an action that covered roughly $1.2bn worth of mortgage-backed securities (MBS).
Today’s rating action concludes the review actions announced in March 2013 relating to the existence of errors in the Structured Finance Workstation (SFW) cash flow models used in rating these transactions. …
In the impacted deals, all collected principal and interest is commingled into one payment waterfall to pay all promised interest due on bonds first, then to pay scheduled principal from the remaining funds. The cash flow models used in previous rating actions, which mistakenly applied separate interest and principal waterfalls, have been corrected, and today’s rating action reflects the commingled payment waterfall.
There are additional mistakes…”