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The Credit Rating Game

by Robert Waldmann

In my teens when I learned of the existence of credit rating agencies I wondered why private firms with such power weren’t corrupt. Why don’t firms pay bribes to obtain high credit ratings ? I still don’t know the answer but I think that the key is that the ratings are determined according to rules and those responsible for a particular rating have limited discretion. Clearly top management is not easily corrupted — the value of the reputation of the credit rating agency is so huge that no client can afford a large enough bribe.

However, while a single firm can’t compete with the value of the reputation of a credit rating industry a whole set of new financial instruments — say CDO’s can. Financial innovation is good for the credit rating agencies as they have more things to rate for a fee. Generous credit ratings for new instruments encourage financial innovation. This creates a conflict of interest between the credit rating agencies and investors who use the ratings to decide how to invest.

A sort of model with no equations after the jump.

If there were only one credit rating agency (call it Serene’s) that agency might just decide that the knew business was worth the possible damage to reputation if it turned out that the new assets became toxic sludge with significant probability. However, I would imagine that competition might keep credit rating agencies honest. That is I would if I didn’t think about it much. So consider another agency (call it Unusual and Rich). If Unusual and Rich is being generous with credit ratings in order to encourage financial innovation, can Serene’s profit by being tough ?

Let me define tough. One of the traditional requirements for a AAA rating is a long history of promptly meeting scheduled payments. for example definitely making payments on time through the most recent recession and for another making them on time on assets identical to the newly issued one for decades. Clearly innovative instruments can’t possible pass this test — the test of time — for decades. Clearly credit rating agencies decided not to consider a decades long clear credit record necessary for an AAA rating.

Economists said this was crazy. Ratings based on means, variance and covariances over a few years will be vulnerable to a peso problem — that is given the data there is no way of knowing that sample means are terrible estimates of population means which are dominated by a huge possible event which hasn’t happened yet (the classic example is devaluation of the Mexican Peso). That’s what just happened.

Clearly a credit rating agency could have said “We won’t rate anything related to housing AAA, because some experts say we are in a housing bubble which will burst. There is no way to know how these assets will perform if indeed a housing bubble bursts. We will consider the possibility of a housing bubble bursting ruled out if no such even occurs in the next 10 years. Maybe you will get AAA in ten years but, for now, the most you can get is A.” Would said agency have profited by saying that ?

First assume that the market for the services of credit ratings agencies is very odd as there are a few players each of which has a market share of 100% (I think this is realistic but I don’t know). That is issuers of credit pay for ratings from all the major agencies — the fees being tiny compared to the added reputational value of a second opinion. This would tend to reduce the ruthlessness of competition.

Now I wonder why, given the value of a credit rating, the agencies don’t charge huge fees. I think the explanation is simple — credit issuers can’t afford to refrain from seeking a rating from an agency when the only explanation of their choice is that the rating would be low. However, if an agency charges fees totally out of proportion with its costs, it gives credit issuers an excuse to not obtain a rating from it. The key is not that the cost of the rating has increased but that the reputational cost of not getting the rating is much smaller when one can claim that the fee is outrageous and one isn’t paying it as a matter of principle.

This limit on fees makes it possible for fees to be so low that credit issuers obtain ratings from all reputable agencies. It can also mean that an excellent reputation is not worth more than an average reputation. This is certainly possible in a repeated game between agencies, credit issuers and investors (pretty much anything is). In common sense terms it depends on what sort of fees seem unreasonable. I’d say people look at profit margins and for some level decide that they are excessive. A credit rating agency profit margin which seems excessive to investors’ profit margin seems unreasonable to investors makes it unnecessary for credit issuers to obtain ratings from the agency to show that they aren’t afraid of the rating they would get.

Assume profit margins are limited by this mechanism to a level which credit ratings agencies can easily obtain if they are equally reputable. Being better than the other agency may be worth roughly zero. This limits Serene’s’ possible gains from being tough.

The first effect of toughness is a cost, credit issuers won’t ask for ratings (it is better to remain silent and be thought a fool than to open one’s mouth and remove all doubt). In the long run, if there is a bubble and it bursts, Serene’s can gain in reputation compared to Unusual and Rich *if* Unusual and Rich just sits there giving AAA ratings to junk. However, Unusual and Rich won’t do that. They will get tough too, because while it is no problem for both firms to damage their reputation it is very bad for Unusual and Rich to severely damage its reputation while Serene does not.

This means that implicit collusion can be maintained. That is, there is an equilibrium in which both agencies give generous ratings to new instruments and both damage their reputations when the crash comes. This is an unusual result. For a plain old cartel it is more difficult to maintain a collusive equilibrium — a firm can profit in the short run by deviating. In this case, deviating to toughness is costly in the short run and well deviating is always costly in the long run because of the other agencies response.

So in this equilibrium, they rate sludge AAA. Then the crash comes and — so what. They all have roughly equal amounts of egg on their faces. We can’t do without credit rating agencies. They will still get as much business rating non-innovative assets as they would have if they were both tough. The new class of assets might vanish, but that was inevitable given the fact that the new assets are very risky and offer modest returns. The agencies profit from the period in which the toxic assets were issued and rated. So long as they gave similar ratings, the damage to both of their reputations won’t hurt them at all.

Of course it will hurt investors who will have to do more research on their own, since they can’t trust the credit ratings agencies as much as they would have been able to trust them in the world without financial innovation.

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Liars Bond Ratings

Robert Waldmann

is reading the article everyone is reading by Michael Lewis on what went wrong. My jaw just dropped. Long long ago, I wondered how bond rating agencies could be so powerful without being corrupted. For months I have wondered how they could get ratings so wrong (and assumed it wasn’t corruption). I’d guessed that, to avoid moral hazard, they worked according to rules which made it possible for financial innovators to game the ratings.

I was wrong. Getting toxic sludge rated AAA was like stealing candy from a baby.

For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.

But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

Now there is something (else) odd about this passage. I thought people re-tranched mezzanine loans, because hedge funds wanted the lowest rated tranches, but I don’t see how their could be confusion on the main point.

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I’m surprised that Paul Krugman is surprised

By Robert Waldmann

Paul Krugman writes

Max Baucus — Max Baucus! — is leading the charge on a health care plan that, at least at first read, is more like Hillary Clinton’s than Barack Obama’s; that is, it looks like an attempt at full universality. (The word I hear, by the way, is that Obama’s opposition to mandates was tactical politics, not conviction — so he may well be prepared to do the right thing now that the election is won.)

I comment

“Tactical politics” indeed and not just for the election. The problem with Obama’s proposa (as you have noted) is that it would create a huge free rider problem which would send the health insurance companies down the death spiral. I’d say that Baucus is, as usual, balancing his desire to improve the world and his desire to serve the health insurance companies whose number 1 priority is a mandate (it is their officially stated condition for supporting reform).

By proposing a plan which would be terrrible, because it would bankrupt the insurance companies, Obama has them begging for the Clinton plan.

Now that is political tactics I can believe in. Also it is not news see ABC June 26 2008 via me

They report that the health insurance trade association will support reform only if there is a mandate.

When bargaining it is useful to start with a proposal which scares the counter-parties. The health care proposal with only advantages for most people (until the system collapses) and huge costs for health insurance companies scared the insurance companies into begging for the Clinton plan. I don’t care if it was Luck or genius.

There is certainly no reason to have expected Baucus to side with Obama against Clinton, Edwards and the insurance industry.

update: In contrast, Yglesias gets it.

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Shopping for Regulators

by Robert Waldmann

Jeff Girth asks “Was AIG Watchdog Not Up To The Job?”

Short answer — no.
Slightly longer answer — that depends, do you think their job was to regulate or to make sure that no one else regulated ? They seemed to think it was the second and managed.

banking regulators and bankers

In 1999, Congress passed legislation allowing banks, insurance companies and securities firms to compete with each other. The new law allowed for a range of possible regulators, from the Federal Reserve to the Securities and Exchange Commission, depending on the mix of financial services a company chose to offer. Holding companies that owned one or more thrifts had the possibility of being regulated by the OTS.

“There was a stampede by commercial and financial firms to get a thrift charter,” said Bart Dzivi, a former counsel to the Senate Banking Committee and now a financial-institutions lawyer in Northern California, “so that OTS could be their consolidated supervisor.”

AIG, like other companies, fell under grandfathering provisions in the 1999 bill and received approval late that year from the OTS to own a thrift in Delaware.


In a March 2007 report on financial regulation, the Government Accountability Office looked at the OTS and found “a disparity between the size of the agency and the diverse firms it oversees.” The report noted a lack of specialized skills at the OTS, which had just one insurance specialist to oversee several insurers such as AIG.

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Felix Salmon explains it all (or at least a few tens of trillions) to me

Robert Waldmann

asked Felix Salmon a question in a comment at Market Movers.

He just responded by AIM (hey does that mean I’m on Felix Salmon’s AIM friends list ? sure does and all I had to do was download and install AIM).

felixsalmon (8:31:29 PM): But I’m interested in a comment you left on my blog:
felixsalmon (8:31:35 PM): “Now as to CDS abuse, tell me a non abuse involving way in which the notional value of CDS is so much greater than the value of all insured D ? If something like that happened with another kind of insurance, wouldn’t you consider it abuse?”
felixsalmon (8:32:18 PM): I think I can answer that quite easily: I enter into a position, and then I unwind it by entering into an equal and opposite position
felixsalmon (8:32:28 PM): and since I’m a trader, I do that many times a day.
felixsalmon (8:32:45 PM): Pretty soon, notional is through the roof, even with no net exposure at all (8:33:02 PM): yes that seems to be an answer (and indeed quite easy).

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Inflation and interest groups in the Carter Years

Robert Waldmann

Matthew Yglesias is very smart, but he is not omniscient. In particular he doesn’t remember things that happened before he was born and it appears that he has fallen for some Republican propaganda.

He writes

In the late 1970s, it just so happened to be the case that the structure of Great Society programs and of then-widespread union contracts meant that the objective interests of union members with automatic Cost of Living Adjustment (COLA) provisions, African-Americans, and public assistance recipients were quite a bit different from the objective interests of other Americans. By contrast, it was relatively easy for Ronald Reagan to assemble a coalition built around lower taxes and inflation that started with the well-off but expanded deep into the middle class. It was actually Carter who began the effort to fight inflation and deregulate certain key sectors of the economy, but that wasn’t a politically sustainable agenda for a Democrat (as witnessed by Ted Kennedy’s very strong primary challenge).

He’s wrong. as I explain after the jump.

The point of his post is that it is hard for Republicans to win elections given widening income inequality that disconnects the experience of their base (the rich) and the majority. True. I’d add that it is hard given high inequality and especially high inequality in (easily taxable hard to hide) W-2 income, since there is so much to be gained for most people from a policy of soaking the rich and spreading it out thin.

But the facts about the 70s are the facts. I was there.

Yglesias seems to be under the impression that AFDC benefits were indexed to inflation. They weren’t. The real value of AFDC benefits declined sharply under Carter. The idea that “public assistance recipients” had less of an interest in fighting inflation than your average non-union worker is simply false. AFDC benefit levels were set by state legislatures and not indexed to inflation. National average real AFDC benefit levels declined sharply during the Carter and early Reagan years, then the decline ended (for a while) around 1984. AFDC plus food stamps declined less sharply (but declined a lot) plus there was a sharp drop 81 to 82 (food stamps are federal). Overall, the recipients of AFDC+food stamps appear to have suffered much more during the Carter years than your average non-union worker.
See here (PDF), page 12.

From 1977 to 1981 the union non union wage differential in the USA decreased from 19% to 16% (17% in 1980) (all very roughly) It is true that inflation crept up during the Carter years. It is not true that this helped Unionized workers relative to non-unionized workers. See here (PDF), page 40.

The Kennedy challenge to Carter had a lot to do with the fact that Carter was generally immensely unpopular (Iran and a recession). Carter’s deregulatory efforts were generally not controversial, mildly popular and barely noticed (I remember I was there). I don’t recall any criticism from Kennedy.

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CDS zero net supply

Robert Waldmann
notes that some have argued that Credit Default Swap demonization is silly because they are in zero net supply so they can’t bring down the financial system (no names or links I will be rude below).

This argument is crazy.

If half the financial firms end up bankrupt and the other half make a killing the disruption will be immense. A gigantic shift from one player to another reduces the sum of their market values. This was shown back in the day by Larry Summers and David Cutler (heard of them) in “The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation,” NBER Working Papers 2418, National Bureau of Economic Research, Inc.

If the firms don’t know who is long CDS and who is short CDS they don’t know who is solvent. Such uncertainty can cause problems.

In any case, the general equilibrium literature contains a huge section on whether assets in zero net supply can make everyone worse off *If* everyone has rational expectations. The answer is yes.

The argument zero net supply so no problem is completely inconsistent with economic theory (so what) and known facts (so there) and no sensible person can possibly take it seriously.

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Kevin Drum makes me blow a gasket

Robert Waldmann

can’t help but argue at very great length that one sentence by Kevin Drum is totally utterly completely wrong.

“The public face of his economic policy, after all, was almost entirely based on tax cuts, a distinctly conservative notion.”

Andrew Sable makes a much better counterargument than mine here.

Mr Drum has fallen for conservative lies. Their actual policies are tax cuts for rich people. Their hero Reagan signed into law a huge tax increase on the non-rich (Greenspan commission proposals). In practice they cut taxes for rich people.

Obama’s proposal has shifted the debate to whether a refundable tax credit is welfare. The Republicans can’t win this one. He has finally used the argument that Republicans can’t answer. Actually Clinton did it too (and was elected remember) but didn’t follow through. Also I think Obama’s proposal is excellent policy. I think Kevin Drum has fallen for the Republican line or decided that popular populist politics is immoral and we should eat our spinach.

I argue both politics and policy at gruesome length after the jump.

The Republican’s favorite trick is to distract people from tax progressivity by pretending that the only choice on taxes is high or low. Obama has shifted the debate to more or less progressive. I have long thought that such an approach to the debate would destroy the Republican party. The evidence from Tuesday is not proof (there were many reasons for the Republicans to lose) but it is still evidence that Obama’s approach to politics works, not just for one election but to change the debate forever. McCain argued “cutting your taxes is welfare. What about all the plubmers who make over $250,000 a year”. This is not (just) because he is nuts. There is no way to convince the American people that they prefer the Republican approach to Obama’s approach.

He was fighting on Republican turf the same way Grant was on confederate turf at Appamatox. With his tax proposal he has stormed their citadel, crushed their army and left them with the choice between surrender and Guerilla warfare (they will chose the second) [earlier historical analogy was the red army was fighting on German turf in the battle of Berlin — it was correctly spelled but politically not ideal).

Drum’s framing is exactly falling for the Republican trick which have made the last 28 years such a political disaster in the USA.

No one but Mondale runs on a platform of raising taxes. Transforming the debate to one about progressivity is more than any reasonable person could hope for from one candidate no matter how brilliant.

Also Obama’s proposal is good policy.

I think the claim is wrong in many ways. First, the Obama tax cuts consist of giving money to non-rich people (at the expense of the rich) and providing incentives for low skilled people to work (setting a good example for their kids).

This approach has been tried at a much much smaller scale by the Clinton administration (the Clinton tax increase included an increase in the earned income tax credit).

Judged crudely the results were spectacular. Of course it was partly luck with investments in information tech finally producing a productivity speed up but the increase in labor force participation, the shift of the Phillips curve etc are exactly what the most extreme advocates of Obama’s policy would have predicted.

In contrast taxing the super rich will, I honestly believe, have good effects totally aside from getting the money (Matt Yglesias has made many eloquent and convincing arguments for this). The super rich are concentrated in finance. This is a big cost as many smart people are not doing other things that are definitely socially useful but don’t make one super rich. The financial geniuses sure seem to have produced something worth less than nothing haven’t they ? Wouldn’t you rather they had been less numerous energetic and creative ?

Causing the financial sector to shrink by taxing the incomes of the top financiers would, I would guess, be excellent policy even if the revenues were wasted (by the way Larry Summers sometimes argues this — one of the issues on which he flip flops).

On the other hand the case for high taxes on low and moderate income is based on … what ?

1) We need money for universal healthcare, anti-poverty programs, green infrastructure investment/subsidies etc etc etc and we can’t get it just by taxing the rich.

A resonable argument (given Obama’s current proposal especially) but not true. The US rich are so rich that there is plenty of money to grab there. The problem is political. Only if people are convinced that taxing the rich has nothing to do with taxing them will it be possible to get the money for the treasury. I had great hopes for Obama’s doughnut FICA increase (which is even more directed at the rich than his income tax plan). I still do even though he de-emphasized it and it might not happen. Then again it might (tax the rich to save social security is the worlds second best slogan after tax the rich and spread it out thin (the current proposal)).

2. It is demagogic populism.

This is true. What’s wrong with that ? If it is good policy, the fact that people support it for selfish reasons or envy of the rich doesn’t make it bad policy.

Here the idea is that politicians prove their virtue by advocating unpopular policies (based on forcing people to face the bitter truth — or in this case the untruth that the US federal government can’t do it’s job and cut taxes for the non-rich).

I don’t want virtuous politicians. I want politicians who win and implement good policies. The fact that something is popular doesn’t mean it is wrong. Look what happened to Mondale.

3 It’s class war. It would be better to unite than to divide.

This is true. So what ? Who said it is always bad to represent the class interests no matter how large the class and how mild the suffering for the tiny class that will be only super rich rather than ultra rich will be.

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Exit Pollster Hell

Robert Waldmann

update: OK after getting burned in 200 and 2004 (to paraphrase our President:fool me once shame on you fool me uh fool … you can fool me twice) only a fool would believe in exit polls tonight (and note the obvious below). But I just can’t help myself.

Looks like the exit pollers are downplaying them everyone wants to tell me how the 71 votes counted in Georgia split. has average exit polls from the MSM financer/suppressors of exit polls.

Don’t start celebrating now, or, if you do, don’t blame me — blame

update 2: According to the exit polls which you should not trust it is McCain by one (1) in Mississippi. Oh my. For what it’s worth Obama is 9.5% above the Pollster trend from regular non exit polls. If I were Senator Wicker I would be worried, but I’m not so I don’t pay attention to exit polls.

notes the obvious.

This is going to be a longgggg day for exit pollsters. Given early voting, they are going to have to pool results from exit polls and earlier results from people who said they voted early in regular polls. This will not be possible without a wild guess.

They have data on how many people voted early and (bad) data on for whom they voted. The data from polls on early voters is based on a much smaller sample size than exit polls and is not based on a balanced sample of polling places, but it is still relatively OK compared to the number they just don’t have.

They will have information on total early votes and on the percentages of Tuesday votes by candidate, but they will just have to guess Tuesday turnout. I suppose they can ask at their sample polling places, but they will only have a number they can use after polls close (and they typically want to release exit polls the instant polls close).

Since it appears that a much larger fraction of early voters have voted for Obama than will Tuesday voters this will be critical. Assuming total turnout equal to 2004 turnout is a recipe for extreme embarrassment.

I’m sure they have some plan (I’m sure they all have different plans).

I’m not sure I’ll believe anything until actual votes are counted (tomorrow night looks like a longgg night over here at EST + 6 hours).

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WaPo on AIG

Robert Waldmann

read Carol Leonnig’s article which quotes many people arguing that the feds should have let AIG file for chapter 11. The point of the complainers is simple, the takeover has been very (realtively) good for counterparties but not so good for the treasury or, it is alleged, AIG shareholders. I don’t see how people can claim that shareholders would have ended up with something after bankruptcy proceedings, but it is costly to the treasury. Oddly no one mentions that the deal was great for Goldman Sachs, I guess that simple observation is too scurrilous for the Post.

I was interested in the discussion of what AIG did wrong.

AIG’s Financial Products division is the primary villain in the company’s free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk.

OK this is simple, there is risk that can’t be hedged by everyone. Someone has to bear aggregate risk. The idea that risk is a problem that can be solved, if one hedges rationally is, uhm, crazy. The idea of an insurance company buying insurance is odd. AIG uhm insures people, helps them hedge, bears risk.

In this case, they took on risk that they shouldn’t have taken on, but there is no reason to think that there was a rational equilibrium in which AIG wrote CDS and then hedged them by shorting the underlying assets.

One can make money by bearing risk or by outsmarting other people. Why would anyone expect an insurance company to be able to outsmart the financial services sector ?

Someone somewhere on the web notes (without naming names) two eminent economists who said that the housing bubble wouldn’t be a huge problem as losses from bad mortgages would only be around $400 billion (similar to the losses when the dot com bubble burst) and the net value of derivatives is zero.

So, assuming people are rational, they will only have an unpleasant surprise similar to 2000.

However, if everyone thinks they are beating the market, because of their clever derivatives trading strategies, the moment of truth for derivatives (bankruptcy in the case of CDSs) will be a very painful shock. The fact that the total supply of derivatives is zero doesn’t mean that the total perceived expected value of derivatives positions is zero.

Similarly if everyone thinks they have hedged aggregate risk by buying and selling derivatives, a mere $400 billion hit which people rated as hedged but it wasn’t can be much more damaging than a $400 billion hit which people knew they might bear.

The argument is that if everyone were rational except for the people writing mortgage contract, then everything will be more or less OK is true, but the hypothesis can’t be reconciled with the volume of trade in derivatives.

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