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 (5^th 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

Turner Construction Company: Project Management System and Buzz 2000 Cases (Current Work)

 First, let me begin with a little autobiography. I have been in my current job for almost 4 years. In the spring of 2011, I was getting my certificate in medical billing and coding. I interned where I am currently employed, and once that internship was over, the woman who I had been working under resigned and suggested that I could replace her. The job was easy. Six months in and I had a clear desk and concern that there was something I was not doing. Having been recently unemployed, I worried about losing my job because I had figured out the processes.

            In late January of 2012, my supervisor the CFO came to me and told me that we were stitching from our legacy payroll / billing / accounting system to a new one. There was worry about data integrity and we could never get the reports we wanted, so we ended up doing a lot of manual counting from printouts. The new system would eliminate that. Instead of one of the off the shelf systems that cost over a quarter of a million dollars, we were using a programmer who had written similar systems. The idea was that we could just pick at the edges and make his database work to our needs. The original goal was to have it working for the new fiscal year, FY13 and we had budgeted about $50,000.

            I could write and write on this one, but the short part is that we are still working on perfecting it, and it is the middle of FY 15. Heck, it is almost over for us. I was still putting things I needed the program today in a list to email to the developer later this week. Therefore, when I read the Buzz’s woodworking project, the thing I could say about it was that it was familiar.

The expansion of Buzz’s was not well conceived at all. John Carpenter seems to want to remake his father’s company in his image. That is what led them to start growing out of the comfort zone to begin with. Buzz had a nice family company and now he wants to get in a cyclical business like subcontracting. We know from the end of the study that the boom in commercial construction that led to the desire to keep expanding ended up not booming anymore. The scale of the boom and the ultimate bust are unknowable. Perhaps instead of being above trend, there was a new normal in development so it of course made sense to expand. I am conservative and I know the future where they do not, so of course it was not well conceived.

            However, it gets worse when you look at the planning. The case brings in no real numbers, just the boom and a possibility of airport expansion with more free trade. None of these is quantified. It is all reasoning from the gut. Even then the decision was made to grow, and the argument was not over that, but instead if they should move or expand. There was argument because it there were no numbers. So they then settled on a rough estimate that became the budget. There was acrimony from key players and no real sense of how long it would or should cost.

The objective of the project was to meet the prospective rising demand by increasing the existing floor area by 25%. To this would be added air conditioning and a dust-free paint shop. Finally, some of the bigwigs would get their offices renovated.

The decision-making was siloed early on. Spencer Moneysworth, the VP of Finance and Administration, took over the project. His first move was to remove the people in production from the process, as they were always busy and would get in the way. He also made several key decisions on his own, such as whom to retain for construction and the bidding process. There was no plan in place, so that each decision was made ad hoc. Moneysworth figured that he needed help so he enlisted an engineer who soon was off creating his own silo of work. The tasks were owned by the individuals, but there was no transparency about the process. Changes were made and that messed up things that had already been finished, making prices higher and time longer. Only when the new equipment came on line did anyone at Buzz’s think to review their process and their decision making, especially since the new equipment was under-utilized. The decisions should have been based off plans that were made at the beginning and then they could see where they were according to the process that was committed to. Instead everyone just dove in and started working without a plan, which is the most important part since it should guide everything else you do. Sure, it takes a little longer on the front end, but it pays off in terms of time and money saved.

            To pay for the project, they at first stuck to the budget that was agreed on at the beginning as s rough estimate: $17 million dollars. From this, the controller took it and broke it up to a million dollar buffer with a 12-month year where they would spend a million in the first and last months and $1.4 million each month as they were really going at it. Then, presumably, the controller took the rest of the day off after all that work. It was not, of course, until the expense exceeded the budget when people noticed that the budget was out but the building is not done. Oops.  Then you have to get more money because of all those sunk costs.

            Ultimately, at Buzz’s, they paid too much for a thing that was not used enough, and it was not really within the original vision of what was wanted when Bruce Sharpe, the VP of Sales and Estimating,  came to the directors with a vision of expanded marketing. The real lesson of this case is that you should never trust the sales people; nothing good comes from it. They are paid to be unfamiliar with the truth. More seriously, the key takeaway is to have a plan and follow it. From having a plan with measurable benchmarks, then you can continually judge “Quality” where you are and collaboratively reassess your plan as you go on. Otherwise, you fail, and you are written up as a case study in what not to do.

            Compared to Buzz’s, Turner Construction Company has their planning nailed down. Now, it may be unfair to judge a one-off project like Buzz’s against Turner, but they are the same thing. How do you go about creating something in an uncertain atmosphere? You have a plan, and you have a quantification of that plan with numbers you capture as often as possible.        

            More specifically, Turner has a system that has worked and continues to work. It takes the guesswork out, as much as possible, and it is much more transparent, so that key things do not end up buried in a pile on some intermediary’s desk. A key component of the Turner Construction Company Project Management System is the IOR or “Indicated Outcome Report”. The projects use this IOR as a way to track risk in the system. This report is updated monthly, with more consolidated ones available quarterly. It is a best-guess prediction at the total cost and earnings projection for a project. This report allows tracking in as near real time as possible and helps Turner make rules-based decisions on preset plans, instead of putting out individual fires as they arose like we saw with Buzz’s Woodworking. There they just set a budget based on what they might think would be the cost and then tried to stick with it but did not have the processes down or the experience to know to outsource the planning while remaining a partner with whoever was implementing the plan. Bottom line is that Buzz’s thing was a mess from start to finish. At Turner they have three types of contingency moneys, one that probably will be spent (C-Holds), those that might be spent (E-Holds) that are set back just in case something changes. They also monitor things to be proactive to potential issues, instead of being reactive.  These two cases are night and day, one shows what to do and another is just as instructive in showing what to do. If there were any weakness in the IOR system at Turner, it would be that there are many cooks and the question is where the final ownership for the numbers lies. Nevertheless, that just feels nit-picky. What is impressive is that they were able to create information in that sort of real time when the case was written. I would expect that they could have rough numbers on a day-to-day basis in terms of cost by now. I am not sure everyone would need that information, but it would be useful to management.

            Concerning the case, my first inclination was to say that there should be no release. Gary Thompson, Philadelphia Territory General Manager, emphasizes that it is an option to say no, even if that is not what he wants to do. My thought was to trust the numbers in the IOR. If it says that we might need that money, especially with a new client, then say “Fie” to the client when they come asking for money they gave you for the project; explain to your manager that short-termism is horrible in the stock market, that if you realize gains in this period, you’re just foregoing them in the next. All that, and you might need that money, so you do not know if you can claw back what was once given from the client. You might realize a gain in this period and offset it not with nothing next period, but with a loss. Accounting tricks will be transparent to the market anyways (assuming market efficiency).

            On a second read-through, I am ready to be more charitable. The numbers are to be trusted, but as Gary Thompson also says, the managers are trained to be conservative with the numbers, so that they do not underbid. That, plus you want to create a good relationship with this client. The market timing is not my concern unless I am planning to sell my personal shares soon, so we can move forward some earnings. The big question is if we can afford it. I think we can. Looking at it now, there are some expected contingencies. The project is already 80% finished, and there is still 1.8% of the original 2.5% contingency left, along with significant C and E holds. My inclination is to free up the money. Looking at it, there is a 4.5% cushion of the total project cost in the various contingencies, which is over 22% of the projected remaining cost. Therefore, unless the remaining twenty percent of the building runs over by almost a quarter, you should be good. Seeing as how only 0.7% of the total project cost of 29 million has been utilized in contingency so far, I would trust the people working on the project enough to free up the cash. A full release still leaves your full E and C hold and $11,000 in contingency or 2.8% of the total cost or a cushion of 14% on the remaining cost of the building. If you trust your IOR, you should be fine, you develop that customer relationship, and you realize some more revenue in this period. Win. Win. Win.

            Releasing the money gets us back to the importance of having a plan, and goals, and measurable. It allows you flexibility based on the information that you have and the faith you have in the data gathering and analysis process. My first response was more akin to someone working at Buzz’s -- reactionary. Better to look at the information and what your goals are, and then you can make decisions smarter and better. This is not done in a vacuum, the processes are important to have lain out, and there needs to be buy-in from everyone as partners in the projects undertaken. This has been one of the most important things I have learned during my time at Concordia. Before I started, I though the real issue with the project I spoke about at the beginning of this essay was about resources. We did not throw enough money at the project. The real issue was that we did not have a plan. We dove in and started, moving from perceived goal to perceived goal with no measurable and creating the illusion of progress. I think the end is near, but planning it out properly would have shaved off so many hours spent on false direction.

Where I'm at now

I've been busy with school. Most of classes have been good so far, because I have been able to cross-post content created for class here. The class I just finished up was a operations management class. I felt checked out of it, because it was so focued on processes in manufacturing, and the closest I have ever come to manufacturing is fast food. The deliverables (and there were a lot) for that class were largely collaboerative responses to business cases, so they lack a lot of context. I felt that posting them wouldn't work as a stand-alone post. It also took me off my reading and responding (reviewing?) game. I have some books I want to talk about, but that's for the near future.
What I've started to do is sound out Directors of Graduate Studies for what I'm going to learn next after my MBA. My wife caught me looking at tuition rates and kind of freaked out, saying "Let's pay for this one first". I also got a promotion at work -- I now have a "Director of Finance" title that is getting to my head a bit.

Anyway, here's the image of myself I created for the DGS at Roosevelt University in Chicago:

I am a lifelong student. My original academic concentration was in English, which I graduated with a bachelor’s in 2004 from WVU and then for graduate school at Kansas State.  The financial crisis of 2008 (or however you want to date it), sparked my interest in the economy and the study of it. I looked into the PhD program at UIC years ago, but at the time I didn’t have the right foundations nor the means to persue it.

I fell into my current position after getting a certificate in Medical Coding and Billing at Devry, and then taking accounting and economic classes at local community colleges.

I am currently finishing up an MBA at Concordia in River Forest. I like the people I have been working with as my peers and my professors, but I feel it has been more a test of how much work I was willing to do an less an intellectual challenge. I undertook it as a practical matter. It helped me get to where I am and that might give me the means where I once did not have them.

I have an ultimate goal to have a PhD. I know that that too can just be a test of the wills. I am uncertain about what I would do with it, as I feels like a Quixotic goal. But it is still something I want to do. Having goals is nothing, though, if you don’t have plans.  I was content to let that simmer for a while. I also worried that it would not be applicable since my own reading in the subject has be outside of the orthodox sphere. I personally lean towards a Marxist reading and I’ll stick with the labor theory of value until I die.

So when I saw that a university local to me was one of the few nationally that support heterodox views, I was happy and wondering why I missed your school in my early researches that ended up fruitless.

Basically, then, I am writing because I have a couple of questions that I could not find on your website. The first is about the practicality of enrolling. I would most likely be only able to enroll part time. Is that precedent in your program. The second is about placement – how many of your students move on to PhD programs, especially ones that study outside of the mainstream.

Robert Putnam's "Our Kids": Compelling Argument Poorly Argued

There’s an epidemic out there. Poor kids these days don’t have a chance, and it’s getting worse.

Robert Putnam, with the help of an uncredited assistant (on the cover, at least), gathered storied of young adults and melded those stories of haves and have-nots with larger statistical trends to tell the story of how the educated class is ,moving away from the uneducated class. There are copious charts and graphs.

I really wanted to like this, since it covers a lot of the same ground as the recent Charles Muarry Book “Coming Apart,” and for ideological reasons I don’t want to read Muarry. The problem is that there’s no hook. The kid’s stories should be what grips you and pulls you into the text, but it doesn’t work. I think there’s too many so I can’t fully live their stories, or perhaps Putnam and company are better analytical thinkers than storytellers for generating pathos. Whatever it was, I was unengaged. It was good enough to finish, but it did not compel me to write marginalia. If you have to read this for a class, it will be readable but it might not pull you in if it is leisure time reading.