Scenario number 1-The Portfolio and Asset Manager
1) You assess an asset class or specific market segment as overbought and risky but the rating agency gives it a thumbs up. You say to your boss I don`t want to buy this, it is a bubble. He is going to say the rating agencies back it, if you miss out on earnings it`s your job mate. What do you do?
Scenario number 2-The Risk Manager
2) A risk system however sophisticated or streamlined at the end of the day finds its magic in statistics and the functioning of all things statistical is predicated on data. In scrabbling to fill the gaps risk managers will turn to any credible sources of data and what a better place than working with a rating agency whose sole purpose in life is to publish default statistics on traded entities. The problem of course is, if the source is broken the risk assessment will be as well, there was no backtest for that.
Scenario number 3-The Regulator
3) A bank makes an assessment on the riskiness of its portfolio`s how can we benchmark their assessment. Sounds innocuous but if I said oh that object is hot, you need a basis to define hot. Hot for a kettle is cold for blast furnace. So these banks are making a statement about their risk weighted assets, let`s use an independent benchmark something not from the organisation to test their assumptions. Sounds logical but where can we find such assessments, the rating agencies and the other pool of banks in a peer who are using the rating agencies.
Scenario number 4-Inside the agency
4) The rating agency needs to make assessments on assets, publish its opinion and charge the world for the assumptions that are drawn, that is how it makes money. Of course all things that are measured require an understanding of the dimension of what is being measured. Some of the instruments that are assessed such as collateralised debt obligations have more than two dimensions. They are bundles of many contracts where each contract has a unique risk characteristic but together have correlation factors that leverages the risk within them. Simply stating a specific CDO is sound because it is made up of thousands of little internal cash flows ignores the correlation factor when you aggregate these cash flows. Oh dear, we didn`t have a measurement tool for that.
So what is broken here? It`s our human nature, we need credible appraisals in life and unfortunately have lost the ability to question ourselves. Perhaps we never had it. I will put it differently, you feel a bit sick you go to the doctor. If you need a quote for a job, you look for a credible technician. To build up your knowledge you speak to more than one of these people. In banking, perhaps other places all these bodies and experts fundamentally draw their knowledge from a single network or pool, a historical museum of shared knowledge so the assessments are likely to be similar.
The solution is a cognitive one. Investors and borrowers alike have to learn to think for themselves. When they buy anything it has a rating and an approval but these people have to understand how that directly affects their world when mixed with the other assets they own. Please understand how that approval is derived rather than accepting it as simply superior authority. When dealing with banks perhaps any system, become heterodox and irreverent to anything packaged and bundled for lemmings.
Gone are the days of trusting the regulator, the rating agency and perhaps even the doctor, certainly a pilot and a lawyer.
As for the banker we are just selling instruments; you, at the end of the day will own the risk in them.
