Risk Rating Reluctance

Managers of many financial organizations are arguably tempted to take too much risk with organizational investments.  Reputation-wise, such managers often gain more from stellar investments than they lose from disastrous ones.  Many regulations try to address this problem by limiting such organizations to “safe” investments, as determined by a few official ratings agencies.  This creates a demand by such managers for assets that are actually risky, but which are officially rated as safe.

Apparently the recent financial crisis was due in part to those official risk rating agencies supplying this demand; they are private firms and profited from applying too little skepticism to whether certain key assets really were as safe as some claimed.  No doubt those agencies say that this was all a terrible accident, that they never intended to profit from mistakenly calling risky things safe, but since they seem to have suffered little from the harm they assisted in creating for others, I have my doubts.

In all the financial reform discussions, I haven’t heard any proposals to address this specific problem.  And I’ve always wondered why we need investment ratings agencies anyway.  In principle, the right financial assets can give any elements you like from a full joint probability distribution over asset returns; how could a ratings agency expect to do consistently better?

At lunch today I asked my wise colleague Garett Jones about this, and he suggested that big financial orgs like being rated by people they can pressure. If they don’t like a rating, they can work their elite-school-alum networks of contacts to apply pressure to the ratings agencies to change unwanted ratings.  Such pressure is much less effective on financial market prices.  Garett also pointed me to this passage of his:

[Remember] the debate over subordinated debt in the early 2000’s, surveyed in Stern and Feldman’s Too Big to Fail. The Gramm-Leach-Bliley financial reform bill attempted to create a class of subordinated debt that would be explicitly banned from any future bailouts.  Major financial institutions would have been be required to hold some portion of their liabilities in the form of subordinated debt in order to give financial markets and regulators alike a market-based measure of firm health: If yields on a major firm’s subordinated debt spiked, that would be a warning sign.  But financial institutions and the Federal Reserve Board both pushed back against this market-based indicator, and so the subordinated debt requirement never made it through the regulatory process. … Firms will resist issuing debt that is bailout-free, and will overwhelmingly prefer debt that is bailout-qualified.

Bailouts mess up the connection between asset prices and their inherent risks.  Ordinarily, market prices only tell you the chance that a debt will be paid, not whether it would have been paid without a bailout.

This is all moderately bad news for prediction markets in such firms.  Apparently well-connected managers already know they prefer estimates by officials who respond to social pressure, over hard-to-manipulate market estimates, even if the later are more accurate.  Of course less well-connected managers should prefer the opposite, but who wants to signal their bad connections by endorsing independent markets?

Added 8a: Unnamed points us to Matt Yglesias responding in Sept. to Kevin Drum and an August Policy Report by Mark Calabria.  Kevin says:

Over the past decade ratings agencies were, at best, negligent, and at worst, perpetrators of outright fraud.

but doesn’t think raters were a big problem because other orgs used similar risk models and both buyers and sellers liked the mis-labeling.  Yet this is just what a corrupted regulator model predicts.  These folks consider switching who pays the raters, or making them a direct government agency, but not replacing them with direct market price risk estimates – why so blind to such an obvious solution?

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  • Robert Koslover

    “Risk Rating Reluctance.” Respectable, but not quite in the league of: http://en.wikipedia.org/wiki/Sticks_nix_hick_pix

  • Eric Falkenstein

    Ratings shopping can happen, but they all paid a big price in the recent financial crisis, so it’s not like they have no disincentive to give out the easiest grade. Saying that the ratings game is ruled by this perverse happening is like saying oil companies have a huge incentive to pollute the environment: it happens, but there are costs.

    There are economies of scale in risk rating. If there’s a standard methodology–and I would say there is–it is more efficient to have a handful of firms give out the B through AAA ratings, than have a hundred firms do so. With a hundred firms rating, that just moves the ratings information problem back one step, rating the raters. S&P, Moody’s, and Fitch all have a long history so their opinions are somewhat validated, and their market value is strongly a function of their reputation, giving them the right incentives. If there were upstarts, often these companies have an incentive to build up an asset class, as when Duff & Phelps oversold junk bonds in 1989 (and then died).

    It’s not a perfect system, but I think having a small oligopoly serves this purpose pretty well. I think the key thing to remember is that Agency Ratings aren’t really novel information, rather, a brand that validates the consensus. Moody’s won’t rate a bond junk if it trades like investment grade, or vice versa. It’s a nice summary stat that increases liquidity.

    • What do these ratings say that the right market price couldn’t say? Or is the rating cheaper than a market price?

      • y81

        But rated securities do carry market prices, and the market prices were giving very much the wrong signals as of 2006. It isn’t as if AAA RMBS-backed CDOs were yielding hundreds of basis points over AAA corporates. In fact, the market is very capable of voting against the rating agencies, and you see it every once in a while, that a security carries a price way out of line with its rating. (Usually, the rating changes pretty soon thereafter.)

        I doubt the cronyism explanation. It seems more likely that (i) the gains from division of labor explain why companies dedicated to due diligence appear, so that other market players can focus on other aspects of the investment process (e.g., duration matching, tax planning) and (ii) the characteristic oligopolistic structure of most mature markets appears in the ratings market for the same reasons it appears in those other markets.

      • y81, the issue is the relative accuracy of the two signals. Yes of course they both make mistakes, but which makes bigger mistakes overall? One key clue: which signal first showed the news of the upcoming crisis?

    • Matthew C.

      It’s not a perfect system, but I think having a small oligopoly serves this purpose pretty well.

      The ratings are crap, garbage, worthless and their aim is entirely politico-regulatory. Their “purpose” is, as Robin mentioned, to allow banks to load up to the gills on high-risk assets (or, conversely, to be able to offload them to some bagholder like the government when things go south).

  • >but who wants to signal their bad connections by endorsing independent markets?


    However, one solution might be to give the problem back to the managers. Let each one put their ass on the line instead of option of blaming others. They are hired to do a job, just do it.

    These abstractions have become so complicated that there is a lack of accountability. No one knows where the failure is. It is a crapshoot.

  • bcg

    Presumably, the people who are less well-connected would have less to lose from signaling that they are less well-connected, and so the trade-off would weigh more heavily in favor of pushing for subordinated debt.

  • Unnamed

    There has been some discussion of ratings agency reform, for instance here by Matthew Yglesias and Kevin Drum. A little more up your alley is this Tyler Cowen post from 2007 citing a David Levy paper.

  • Prakash

    Isn’t there a regulation that funds have to use them? Why look for complicated explanations when there is a legally mandated oligopoly?

  • The Gramm-Leach-Bliley financial reform bill attempted to create a class of subordinated debt that would be explicitly banned from any future bailouts.

    I’m stunned that anything this intelligent got this far in Congress and it’s even sadder that the Federal Reserve helped kill it. I think this one piece of information, especially if it can be confirmed that the Federal Reserve was one of the villains, does more than anything else I’ve read to convince me that the Federal Reserve is evil. This is exactly the sort of brilliant technocratic move that they are supposed to be promoting.

    • James K

      Evil’s probably not the right word. It’s far too easy to think you can master even something as complicated as economic cycles. Macroeconomists really believed that The Great Moderation was a permanent phenomenon and the business cycle had been tamed. Something like the subordinated debt market basically tells the Fed they can’t do their job, and they reacted predictably to a challenge to their status. Add in the common distrust of market mechanisms, even among some economists, and you get fervent opposition to a sensible idea.

      None of this excuses their behaviour. If you’re going to be put in charge of a part of the economy, you have an obligation to understand your own limitations, and put your ego on a shelf somewhere.

    • drscroogemcduck

      maybe they opposed it because they thought having debt that was explicitly bailout free would mean that people would expect other debt would always be bailed out

    • It is not that the Reserve and other regulators opposed the proposal quietly behind the scenes to get Congress not to pass it. It is that Congress passed a rule and then they refused to enforce it.

      • James K

        OK, that starts to shade into evil.

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  • Charles Calomiris says that it’s regulation that requires some buyers of securities to have them rated as of the safest grade.

    Still, why would asset managers want to take on garbage that is rated safe? Calomiris says it’s because managers were paid according to volume of assets managed, not ROI or something like that. Bringing in a sheerly big amount of stuff — promising or not — was what got you big bucks.

    If managers at lower-status places were also paid according to volume of assets managed, that would explain why they too wanted safe-rated garbage.

    That’s how grade inflation works in education. It’s the higher ed orgs that demand grade inflation — that way a school can take in a larger volume of students. “Hey, they were rated with a 2.5 GPA and 1000 SAT, so don’t look at us!” And of course school managers get paid according to how many students they take in, not based on how well they predicted student success, how much they improved a student, etc. Just pack more of ’em in and watch the tuition, grants, and donations roll in.

    • Benquo

      How would lowered standards allow an asset manager to buy a greater volume of stuff? All else equal, they’d still have the same cash constraints, and the only thing that lets you buy more than you have cash for is leverage, not high ratings.

      You could make the argument that collateralized borrowing was a way of transforming “safe” garbage into leverage, but much more important was the fact that asset managers often were rewarded for (short-term) ROI, and “safe” garbage allowed them to chase higher yields without appearing to take greater risks.

      • Grade-inflated securities allow managers to take in more if what those managers are allowed to hold by government regulation must clear some grade threshold.

        Imagine a world where everything is rated B, but regulation requires that you only hold A-rated stuff. Your volume of assets managed is 0. Now demand and get grade-inflation by one letter, so that everything is rated A. Now you’re free to take in whatever you want.

  • Eric Falkenstein

    Robin: you can’t make money trading bonds using ratings; ratings info (current, past changes) does not ‘Granger cause’ future bond price changes. So, they are redundant in that sense. However, of about 1500 rated nonfinancial US firms, probably only 450 have liquid prices that would not be susceptible to manipulation if they were a focal point for some big regulatory or indirect benefit. Bonds are not nearly as liquid as equities Illiquid prices are often quite informative, but only if they don’t have a lot of indirect value, in which case they will become biased. When markets are not liquid, a rating consistent with an illiquid price makes participants more willing to assume that a price is not bogus, so it adds liquidity. Liquidity is worth something for the issuers, so this raises their market value.

    • But if some tried to trade to manipulate apparent risk down, other speculators would eagerly make counter trades for profit. And bond ratings can also be manipulated as we’ve seen. Is there any evidence that less liquid bond prices are or would be more distorted from manipulation?

      • If you buy low and then refuse to sell, speculators can’t create a liquid market. So – though I suppose this is also obvious – you’d have to allow naked shorting of the market.

      • Er, buy high.

  • There was no one, or hardly anyone, doing this rating workwho had the remotest connection to the real world of finance or the common sense of markets. The departments were populated with young math and science graduates, largely from third world countries, who were studying CMBS instead of fruit flies or gamma rays because the pay was slightly better and they imagined it might lead to real Wall Street jobs.

    • y81

      Of course, this totally undercuts Mr. Hanson’s cronyism explanation, since the ratings agency staffers clearly hadn’t lived in Davenport or Eliot House, being from Bombay. Mr. Smith’s sociology is certainly closer to the truth than Mr. Hanson’s.

  • Eric Falkenstein

    There’s no evidence, just anecdotal stories about poorly marked bonds. Unlike equities, bonds are often held a very long time, because the transaction costs are so much higher. I know that illiquid bond prices are a real problem, in that people in that space have a lot of protocols to protect themselves from relying on prices from brokers on bonds they quote but do not trade. Illiquid asset prices make volatility seem low (Andy Lo has done work here), merely because it seems like zero until a big move makes this untenable, which is why monthly return data should not be used to estimate Sharpe ratios on illiquid strategies.

    I guess its part of a general problem. Say you have a prediction market, that has an open interest of $100k. You find it predicts some target pretty well, looking at 10 years of data. If you then use that market to make a decision worth $10MM, I would be wary that the past performance of that predictor would be the same.

  • Eric, the issue is the relative accuracy of market prices and agency ratings, both under the assumptions that such estimates are relied on. Corruption goes with agency ratings, and with market prices that were relied on there would be attempts at manipulation via trades. That price manipulation would induce more trading and more liquidity by speculators attempting to profit from pricing errors. Shouldn’t we at least *try* this market price method of estimating risk to see how well it compares to agency rating?

  • Eric Falkenstein

    I guess I was making the more modest argument 1) having a duopoly generate conspicuous validation has real value and 2) adding functionality to the bond price introduces new issues around fraud and gaming, especially in illiquid bonds. Lots of people seem to think agency ratings are useless or intrinsically corrupt.

    But ultimately, I totally agree that bond prices should be used by anyone interested in evaluating a company’s credit rating–it’s clearly more important than anything else (bond prices Granger cause ratings changes). Anyone doing credit analysis finds a market price of credit as their most prominent datapoint.

  • Bob

    I know that derivatives are in the dog house but you can solve the illiquidity problem (which is real) with a futures market for the sub debt market (of course, futures markets are basically prediction markets). Which, BTW, everyone who understands the problem knows is the real solution if you can meaningfully precommit to “no bailout.” It does not have to be an ironclad commitment, just substantial risk, to convey information about the downside.

    Of course, you need a capped upside too – the reason that stock prices don’t work is that they do not necessarily fall when firms take terrible risks (think call options), at least until the risks blow up. We actually have an example of this in Fannie and Freddie – bondholders were bailed out but preferred stockholders were not. Any future issues of GSE preferred stock will provide the risk-taking signal Robin seeks. Which is why I don’t expect any future issues…sigh.

  • Eliezer, Phil Gramm was an economist before he went into politics, so that could help explain how the idea got as far as it did.

    David Smith/y81, perhaps the young workers were math whizzes from Bombay. But what about management? Might the bosses have had chummy connections with those of the firms they were rating?

  • y81

    Regarding the relative accuracy of bond prices and credit ratings, bond prices are certainly swifter in their responsiveness to news (e.g., news of higher-than-expected levels of subprime mortgage defaults). On the other hand, the bond market is like the stock market, which has correctly predicted nine of the last five recessions. So if you look at, for example, LIBOR (not strictly a bond price, but it’s the same idea) or AAA CMBS yields, the volatility over the past 18 months doesn’t necessarily seem that meaningful.

    It’s a little like asking whether Intrade is more reliable than an average of polls. Normally, they track so closely that there’s not much to choose. Intrade obviously moves more when there’s breaking news.

    • Has the stock market actually “predicted nine out of the last five recessions”? Scott Sumner usually says 1987 is the one time the stock market crashed but we didn’t get a recession.

  • Robert Bloomfield

    So far, I haven’t seen anyone in the comment thread mention one of the most important details of ratings: credit rating agencies are not covered by Regulation Fair Disclosure (FD), so they can get information about debt securities that are not public knowledge (and that firms wouldn’t disclose publicly due to concerns about revealing proprietary information). There may be reasons to question whether the ratings agencies used their additional information effectively, but a prediction market would not be a solution, at least given the existence of Reg FD.

  • Kenneth Switala

    There appears to have been some type of market risk reform for the housing market in the United States, called the Home Valuation Code of Conduct. There is no blindness at all to preventing risk fraud in small doses, but not enough political will to turn something like it into law on a larger scale. Also, The congressional bill HR 3044 seeks to impose a moratorium on this agreement.