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March 03, 2009
The Rating Demons: Why they are the real demons and the case for nationalizing them before any possible nationalization of the banking system
Since August 2007, Banks have been derided for their role in causing the current mess in the financial sector, which has clearly spilled over into the real economy. And to my mind, the banks thoroughly deserve it.
Regulators too have faced a lot of flak. Their mistakes are almost entirely by way of omission rather than commission. Let me elaborate. Prior to the current crisis, some Financial Stability Reports (published by various Central Banks and some supranational agencies) had pointed out some of the same lacunae that are now being 'found' post-facto. One such report, which I remember is the Bank of England's Financial Stability Report (July 2006). I have selected some of the relevant extracts and compiled a note at the end. While there seems to have been an appreciation of the systemic risks by atleast some Central Banks...very little was effectively done to manage these systemic risks a priori.
In his recent comments, the ECB President Trichet said
...The current crisis is a loud and clear call to extend regulation and oversight to all systemically important institutions – notably hedge funds and credit rating agencies – as well as all systemically important markets – in particular the OTC derivatives market...
Until recently, the hedge fund industry was the favourite "whipping boy" for most commentators and that is principally because the typical hedge fund has short horizons and high leverage.And while the hedge fund industry should be required to report their activities--for better market surveilance of their activities, I find no wrong with their buiness objectives. The key control has to be market surveilance (to ensure non-manipulation of markets) and reduction is counterparty exposure of systemically important institution to hedge funds. Banks may have replaced hedge funds as the favourite "whipping boy"---atleast temporarily. Interestingly, Rating agencies have been largely spared by most commentators. Perhaps, because the damage caused by them is not so easily quantifiable. It is my case that the Rating Demons are by far the biggest cause of concern (out of banks, regulators, hedge funds and rating agencies).
Before I try to justify my case, please consider the following two data points in relation to the US:
1. The total bailout disbursements made till 18-Feb-09 is US$ 337 bn (out of the US$ 700 bn available for disbursements). Besides, guarantees of US$ 1.98 trillion have been announced (Source: Grail Research Bailout Tracker).
2. As per Federal Deposit Insurance Corporation data, FDIC-insured Commercial Banks and Savings Institutions have paid income tax of U$ 678 bn in the period 1992 - 2007. This period roughly begins after the previous major financial sector crisis, namely the Savings & Loans crisis.
The then non FDIC-insured banks such as Goldmansachs, Merrill Lynch,...,& insurance companies such as AIG; would have paid taxes over and above this US$ 678 bn (and this has not been adjusted for inflation for considering the US$ of today).
The eventual cost of bailout will depend upon the salvage value of investments made, the guarantees that actually require the guaantor to perform, the value of rights acquired while extending guarantees,...
The Swiss government actually made a profit on its previous bailout of UBS. Whether, the eventual cost of bailout is in excess of the taxes collected from the banking system or not will only be known at a much later date. Its possible that the banking system may still be revenue positive for the exchequer, net of the eventual cost of bailout. If and when we consider complete (management control and permanent)nationalisation of the banking system we would have to ask whether the nationalised banking system would generate higher revenues for the exchequer, net of future bailouts? And to my mind this is a necessary (but not sufficient) question which needs to be answered before permanently nationalising the ownership as well as management control of the banks.
The rot in rating agencies seems to be much more widespread. I found the evidence damning.
...e-mail messages cited by the House Committee on Oversight and Government Reform that showed two analysts at S&P speaking frankly about a deal they were being asked to examine.
"Btw — that deal is ridiculous," one wrote. "We should not be rating it."
"We rate every deal," came the response. "It could be structured by cows and we would rate it."...
But, surely one rotten apple does not cause the whole basket to rot!
So, read this:
...The Securities and Exchange Commission in a July report found the credit-rating companies improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.
An e-mail that a S&P employee wrote to a co-worker in 2006, obtained by committee investigators, said, ``Let's hope we are all wealthy and retired by the time this house of cards falters.'' ...
And for the most damning part read this:
...It amounted to a ``market-share war where criteria were relaxed,'' says former S&P Managing Director Richard Gugliada.
``I knew it was wrong at the time,'' says Gugliada, 46, who retired from the McGraw-Hill Cos. subsidiary in 2006 and was interviewed in May near his home in Staten Island, New York. ``It was either that or skip the business. That wasn't my mandate. My mandate was to find a way. Find the way.'' ...
...Moody's could produce a lower default rate by incorporating a decade of ratings stability for structured finance into its assumptions. The average five-year loss rate on U.S. structured finance products between 1993 and 2003 was 1.9 percent, compared with 6.3 percent for corporate bonds, the company had said in September 2004. A drawback was that raters didn't have data going back to the 1920s, as they did on corporate bonds.
In a press release on the report, Moody's said ``structured- finance ratings are broadly comparable in quality to the ratings of corporate bonds.''...
...Philippe Jorion, 53, a finance professor at the University of California, Irvine, criticizes the Moody's decision to factor ratings stability into its evaluations.
``This uses the output of their model as input into their models,'' Jorion says. ``This type of model is totally out of touch with the underlying economic reality.''...
...according to an Aug. 17, 2004, e-mail obtained by Bloomberg. Managing Director Gale Scott warned of the ``threat of losing deals'' to Moody's unless the company relaxed its rating requirements.
``OK with me to revise criteria,'' replied Gugliada, then S&P's top CDO-rating executive, the e-mail exchange shows...
...Gugliada says that when the subject came up of tightening S&P's criteria, the co-director of CDO ratings, David Tesher, said: ``Don't kill the golden goose.''...
The three main rating agencies worldwide are Standard & Poors, Moody's and Fitch Ratings. S&P is a unit of McGraw-Hill Cos. Moody's is a unit of Moody's Corp. Fitch is a unit of Paris-based Fimalac SA.
McGraw-Hill Cos paid taxes of US$ 5.9 bn in the period 1998 - 2008.
Moody's Corp paid taxes of US$ 1.9 bn in the period 2004 - 2008. Fitch Ratings generated an operating profit of EUR 178mn in fiscal 2008.
Thus, even by very conservative estimates the rating agencies would have paid less than 2% of the taxes paid by the banking system. And what portion of the current financial crisis can we attribute to the rating agencies? Its not possibly to precisely quantify this...But, consider the following: even if only 10% of the current mess is attributable to the rating companies (I think 10% is an under-estimation), the rating companies are still worse than banks by atleast five times -- because the Rating Demons cause a five-fold damage (requiring bailout) corresponding to every dollar of revenue generated for the exchequer by way of taxes, in comparison to the banks' damage (requiring bailout) corresponding to every dollar of revenue generated for the exchequer by way of taxes.
While decisions regarding nationalization, should take into account a whole lot of issues...I think the above metric i.e. ratio of damage to the contribution to the exchequer(for a defined period) should not be ignored especially when it turns out to be decisively in different in comparisions.
In comparison to the banks, the Rating Demons are a much more surer case of privatizing profits and socializing losses.
If the picture in the rest of the free market economies is similar to that in the US economy, the above conjecture will substantively hold for rest of the free market economies too.
I think nationalization of the Rating Demons should logically take place prior to any serious talk about the nationalization of the banking system!
WHAT DO YOU THINK?
NOTE : The following are some of the relevant extracts taken from the Bank of England Financial Stability Report (July 2006):
The Report
discusses two extreme but plausible scenarios:
• A sharp turn in the credit cycle: There are several potential supply-side factors (for example, a marked further rise in oil and other commodity prices) which might prompt such a reassessment of creditworthiness. Were the credit cycle to turn sharply due to these forces — for example, on the scale of the early 1990s recession in the United Kingdom
— it would have implications for, in particular, the corporate and household vulnerabilities.
• A substantial further fall in asset prices: Despite recent market movements, an abrupt and widespread rise in risk premia and risk-free rates would have important implications for, in particular, the low risk premia, global imbalance, household and corporate vulnerabilities.
…could trigger additional amplification channels…
In such severe stress situations, certain structural features of
the UK and global financial systems, which have grown in importance over the past few years, could amplify market and credit risks. For example, UK and international institutions have increased their exposures to potentially illiquid instruments over recent years. Given their potential illiquidity,a rapid unwind of these positions in the event of losses would tend to depress prices by more than has been the case in the past, particularly if many investors were pursuing similar strategies in such markets. The adjustment in the prices of some risky assets during May and June illustrate these effects.
On the liabilities side of the balance sheet, UK banks’increasing dependence on wholesale funding has heightened their sensitivity to liquidity developments. Increasing linkages within the UK financial system — for example, arising from interbank and counterparty exposures between UK banks and LCFIs — would also amplify the transmission of risk at a system-wide level. All of these factors would tend to increase correlations between asset returns in a stress scenario, thereby reducing some of the diversification benefits that appeared to exist when correlations were low. Again, recent market developments perhaps illustrate such effects, albeit on a limited scale.
...What actions are needed?
A range of actions might usefully be taken by both the private and official sectors to insure against these risks...
A third priority area is liquidity risk management, in particular liquidity risks arising in markets for new and complex instruments. More work is needed on appropriate liquidity standards for firms and liquidity stress tests, both domestically and
internationally...
Trading revenues and Value-at-Risk...These institutions experienced a 50% increase in trading revenues in 2005, but this was
accompanied by only a relatively small increase in their VaR(Chart B). This could mean that firms are diversifying their portfolios more efficiently. But it may also support the widely held view that VaR is an imperfect measure of risk in the trading book...
Collateralised debt obligations and risk...Systemic stability also relies on investors knowing what risks they are bearing. The very complexity of these instruments makes it difficult for investors to determine precisely how exposed they are to particular risk factors. The potential losses, and hence the market values, of CDO tranches are dependent on default correlations within the existing portfolio, which are difficult to calibrate. Modelling difficulties can also lead to errors in hedging, so traders can find themselves with residual exposures that they thought they had hedged. In such situations, they may wish to reduce the residual exposure if credit losses rise. But with the liquidity of CDO markets still developing, especially for some of the more complex instruments, a shortage of secondary market liquidity could potentially amplify price movements in the event of a shock...
Posted by amgodbole at March 3, 2009 04:27 PM
I couldn't agree with you more on the rating agencies. So long as these are for profit businesses ratings will have no value. In my view rating agencies need to be folded into a nationally funded agency with complete independence.
Posted by: Kalyan Sunderam at March 6, 2009 11:37 AM
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