Monday, April 26, 2010

Gillian Tett and Paul Krugman on the "murky world" of credit ratings

The FT's Gillian Tett welcomes last week's publication of the rating agency emails:

Another week, another bout of e-mail embarrassment. Goldman Sachs shot into the spotlight 10 days ago, after the Securities and Exchange Commission accused the bank of fraud and released e-mails written by Fabrice Tourre, a trader, describing the financial products he created as useless “monstruosities” (sic).

A senate committee released a fresh batch of documents at the weekend, including e-mails from senior Goldman officials crowing that the bank could make “serious money” from America’s mortgage disaster. These will be debated in Washington on Tuesday.

But these have not been the only electronic howlers. A senate committee last week released e-mails from Standard & Poor’s and Moody’s which revealed something long suspected but never proven: that from 2005 the rating agencies faced growing pressure to cut corners in how they rated complex credit instruments in order to win lucrative business from banks....

It is fascinating, almost touching, stuff. Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working. But by 2007 they, like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also in a strange, geeky silo, into which few non-bankers ever peered...

There are two important lessons. One is that what went wrong in finance was fundamentally structural, as an entire system spun out of control It might seem tempting to lash out at a few colourful traders but that is a sideshow: what is needed is systemic reform that removes conflicts of interest.

The second lesson is that the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.

And in the NY Times, Paul Krugman:

What those [rating agency] e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

The rating agencies began as market researchers, selling assessments of corporate debt to people considering whether to buy that debt. Eventually, however, they morphed into something quite different: companies that were hired by the people selling debt to give that debt a seal of approval.

Those seals of approval came to play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.

It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt — which increasingly meant Wall Street firms selling securities they created by slicing and dicing claims on things like subprime mortgages — could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.

And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.

These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. Paul McCulley of Pimco, the bond investor (who coined the term “shadow banks” for the unregulated institutions at the heart of the crisis), recently described it this way: “explosive growth of shadow banking was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out fake IDs.”

So what can be done to keep it from happening again?

The bill now before the Senate tries to do something about the rating agencies, but all in all it’s pretty weak on the subject. The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in “knowing or reckless failure” to do the right thing. But that surely isn’t enough, given the money at stake — and the fact that Wall Street can afford to hire very, very good lawyers.

What we really need is a fundamental change in the raters’ incentives. We can’t go back to the days when rating agencies made their money by selling big books of statistics; information flows too freely in the Internet age, so nobody would buy the books. Yet something must be done to end the fundamentally corrupt nature of the the issuer-pays system.

An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University. They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.

I’m not wedded to that particular proposal. But doing nothing isn’t an option. It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

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