Tuesday, May 19, 2015

Shun the Rating Agencies



In the fifth edition of Kinickic and Hill’s Organizational Behavior, the authors present the reader with a potential ethical dilemma. At the end of the ninth chapter, the reader is introduced to the ratings agencies (248). The authors call these agencies the “missing character” in the story, and with good reason. Briefly, the reader is exposed to the role in the ratings agencies had in the financial crisis. They call the ratings the agencies – Moody’s. S&P, and Fitch – give as “grades”. They carry forward this metaphor by telling that the securities grades are important because there are some institutions that cannot purchase securities with low grades. The ethical dilemma comes in where the securities did not behave as well as the grades given, and the institutions that had bought well-graded things turned out with failures. The problem is that there is no recourse with the ratings agencies, because they are not legally responsible for the ratings, hiding behind the first amendment and calling these ratings “Speech” (. The secondary problem is that there actually exists competition between the ratings agencies. The can be played off of one another, and they need business. The companies creating the securities to be rated are the ones who pay the ratings agencies, so there is a potential for the companies to go ratings shopping and find the best rating amongst the three main companies. Alas, that is a secondary problem not developed in the text of the book.
What the authors miss is that the grade that the ratings agencies give is a measure of risk. If you buy this security, what are the chances that it would fail? A grade of “A” means that there is basically no chance it will fail. If a ratings agency knows what assets are backing a collateralized debt obligation (what the authors call “‘creative’ with their mortgage related products” (248)) then the rating should be easy to determine based on past history of the bank creating the security and back by similar assets. If a city creates a bond backed by parking meter revenue, all the rating agency needs to do is look at the past revenue from parking meters and project that future growth with a range macroeconomic assumptions to figure out what the chances are that the city will no longer be able to pay and thus default on their bond payments. The agency figures out that risk, and then slaps a rating on that. The higher the rating, the higher the price they will be able to get and lower interest rate they will have to pay. With real-estate backed securities, the mechanism was the same. There is a future cash flow – the house buyers paying their mortgages. There was anticipated growth in the mid-aughts based on the housing bubble. The banks did not just make a bond based on one house. No, they were more clever than that. They took the cash flow of mortgages all over the country. In theory, this meant that if one house or local real-estate market has issues, the bond as a whole would be fine. The ratings agencies took these assumptions, and accepted these, and offered up bonds that were rated AAA, meaning that they had the same minute risk of failure as the government of the United States. It turned out their assumptions were wrong.
Where they were wrong is one word: correlation. The make-up of the bonds was assumed as if one house failed, or one city failed, the bond would be insulated from that failure due to the diversity of assets backing the bond. The problem is that this only holds true if there is no correlation. Correlation is a measure of how often things go together. If an economist ran a study of how related sales of pencils were with the number of rainy days, she might not expect them to be related. But if she then ran a study looking at how related sunny days were with ice cream sales, she might expected to see a spike in ice cream sales when the sun was shining. The models built by the banks and accepted by the ratings agencies thought that the housing sales in different American cities that they used to back bonds were like clouds and pencils; instead, they were like sunshine and ice cream. In hindsight, it seems logical that the housing markets in Phoenix and Atlanta were undergoing the same processes. They were both going up with abandon. Between 2000 and near the peak in 2005, home prices in the Phoenix increased almost 120%, according to the widely respected index of home prices compiled by Case-Schiller (S&P/Case-Shiller Phoenix Home Price Index). While Phoenix was a national outlier, Atlanta went through the same exuberance. According to Case-Schiller, area home prices increased 30%. Both areas subsequently went through drops of a magnitude similar to their rises. This correlation meant that the bonds that were built to fail only in the unlikely event that houses everywhere lost value and people started defaulting on their loans ended up failing because people everywhere started defaulting on their loans when house prices stopped going up at a much greater rate than they had in the previous century.        
The only thing that could have saved those bonds, and in turn the entire financial system, was if house prices never stopped going up. The question is if the ratings agencies should have seen the house prices eventually going down nationally and if they should have seen that correlated bonds backed by real estate should not be rated with as low a chance of failure as the United States’ government. These being the ratings, remember, that creates huge markets for these bonds because there was no restriction on their purchase and fueled the market for more bonds and more mortgages because everyone wanted a piece of the action. Then when there were no more qualified buyers and the market dried up and those bonds started failing – everyone was holding them. They were held by banks as their solid assets, and backed by insurance companies who also thought that they would never fail. AIG almost went bankrupt because they did not have enough capital to pay off the insurance they offered on the Mortgage Backed Securities. Why would they even need to hold capital, those things were rated AAA?
The crux of the problem is that the agencies were handing out ratings without any recourse. The collapse of housing prices is easy to see in hindsight, but to remember the mid-aughts is to remember the home price hysteria. There was more than one show on cable about how easy it was to get rich flipping houses. The media had a field day after the crash looking at isolated examples of people who had bought houses with little money and little cash flow – the so-called “NINJA” or “liar” loans. The myopia of people convinced that this time was different was more than just the individual borrower, and it was institutions and not the individual borrower who bought into the hype. At the center of it were the ratings agencies and the banks. The banks have long struggled to lobby against regulation, culminating in the Gramm-Leach-Bliley Act of 1999, signed into law by President Clinton (Investopedia). The law effective dismantled New Deal regulation that made it illegal for commercial banks to also be investment banks or insurance companies. With the regulatory environment relaxed, the only hope in restraining the banks is the ratings agencies, which are private companies but have an interesting statutory role. The three main agencies with a couple other companies are designated “Nationally Recognized Statistical Rating Organizations” by the SEC. This means that the word of the ratings agencies is almost law (Marston). Being quasi-public bodies, they should be culpable for their mistakes.
The question then is should they have known that price of the various housing markets would fall and then the bonds that they said had almost no chance of failing would then fail? That is a place for debate. There is a theory popular amongst some economists called the “Efficient Market Hypothesis”. Part of this hypothesis is that, in its strong version, that prices are always right. That means that there can be no such thing as a bubble where prices diverge widely from their underlying value and then subsequently fall back down or below their underlying value. This view had a lot more adherents in 1995 than it does now. The argument that bubbles cannot happen was seemingly disproven late in the Clinton presidency, and the ratings agencies should not have been so cavalier with their high ratings. That said, they are private companies so what sort of recourse can be had against them? To sue them in court the government would need to prove knowledge of malfeasance where it looks more like negligence. To bring suit against the, would be to bring suit against capitalism. The ratings agencies were just being paid to bring their knowledge and experience to bear against the chance that a security would fail. The argument would follow that their rating is just one piece of information that an investor should take into account when purchasing a security. The law assumes that there is full information available, and the investor is well informed then the only negligence is if the issuing bank withholds pertinent information. The agency is thus absolved of all guilt.  The weird thing though is that the agencies give their ratings in letter grades, which is a simplistic act. The letter grades make it seem as if they know that they are not in fact serving an entirely well-informed buying public but instead one that is relying on heuristics to judge the quality of the securities. This is the one job the rating agencies have and they demonstratively failed at it.
The solution to the problem is to start freezing the agencies out of their role and bring the rating responsibility into the government. There is a multitude of bodies one could pull experienced individuals from the alphabet soup of finance-related agencies in the national government to serve as new ratings boards. The SEC had essentially deputized these agencies with the ratings responsibilities, so the new government ratings body should be housed in their walls. The private sector should not complain about this move too much, since securities rating falls under the definition of a public good. A rating is both non-rivalrous and non-excludable. The ratings should be more like a utility than a token that goes to the highest bidder.
References

 

Investopedia (2015). Gramm-Leach-Bliley Act of 1999 – GLBA. Investopedia. Retrieved from http://www.investopedia.com/terms/g/glba.asp

Kinicki, A., & Fugate, M. (2012). Organizational Behavior: Key Concepts, Skills, and Best Practices (5th ed.). New York: McGraw-Hill Irwin

Marston, R. (2014, Oct 20). What is a rating agency? The British Broadcasting Company. Retrieved from  http://www.bbc.com/news/10108284

S&P Dow Jones Indices (2015). S&P/Case-Shiller Phoenix Home Price Index.  S&P Dow Jones Indices. Retrieved from http://us.spindices.com/indices/real-estate/sp-case-shiller-az-phoenix-home-price-index