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
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