Robert Waldmann has advice for libertarians:
I’d look into the Lucas critique — when policy makers assume that an
empirical relationship is a natural law and attempt to exploit it, it
disappears. In particular the usefulness to private agents of the
ratings caused regulators to decide to use them too (and destroy them)
via Basel II.
Along related (but contradictory) lines, in The Economist Alan Greenspan calls for higher capital requirements. The arguments of both Waldmann and Greenspan make perfect sense. The problem of course is defining "capital" in such a way that is not counterproductive. You know the old joke:? "Capital requirements: can’t live with ‘em, can’t live without ‘em."
The Lucas critique sounds like Goodhart’s Law.
Wow, that Waldmann piece is a hoot. Having a clue as to what you are talking about certainly isn’t required to have an elaborate opinion, is it?
It would be hilarious to read except it’s so tragic – almost no one appears to understand the actual business practices that drove the system. Couldn’t someone bother to ask?
Basel II wasn’t even published until 2004, but the problems at the credit rating agencies have been documented back to 2001. And worse for Waldmann’s, um, “thesis,” is that Blythe Masters invented the super senior in ’97-’98, so Basel II certainly wasn’t an issue in their creation or initial business use.
As for his ideas about the ratings – which are so confused I can’t even follow all of what he’s trying to say there – someone needs to explain to him the difference between seniority and credit rating. Sheesh.
The credit ratings agencies form a legally protected oligopoly since 1975. And much US law requires high ratings for a variety of securities, so the agencies are now in the business of selling high ratings. Most investors (including Waldmann, apparently) did not know this, it seems. Hence last Sunday’s front-page NYT expose of furious emails from top institutional investors that Moody’s had “let them down” by rating MBS AAA.
@Jeffrey Friedman
“the agencies are now in the business of selling high ratings. Most investors (including Waldmann, apparently) did not know this, it seems”
Um, except they did. The ratings agencies have been charging issuers fees since the 1970s, this is hardly a new practice. S&P helped Morgan put its very first such deal together, Bistro, long ago; the agency always been part of the business process. But now suddenly, there’s surprise? I think not.
@pytheian
“decreasing incentives for banks to monitor credit quality themselves”
This may shock you, but may I politely note that the rating agencies have been rating credit quality since, oh, 1909? Rating everything and everyone became a more common practice in the ’70s. You really can’t say that suddenly in 2005 people did wrong by relying on the agencies. People safely relied on these agencies for at least 80 years.
The question those-who-would-be-insightful should be asking is: what changed at the agencies in 2000?
But if you want to argue that the banks should have monitored every loan themselves, let me ask you how could they have? Each one was pooled and sliced, and further one of the interesting things about these instruments is that you could substitute a piece for any other similarly rated piece.
You can’t fault the pooled-n-sliced MBS either, because it was invented in late 70s and worked quite well until recently. You would again be better off asking: why did something that worked great for more than 30 years thru various conditions suddenly fail?
Well taken, Streetwalker. I read an article a few weeks ago (I think it was Michael Lewis’ post mortem on the MBS meltdown, forgot the outlet) which stated that at least one of the ratings agencies was employing a model that was not built to account for a fall in house prices as recently as 2007. Good reason not to trust them beginning around 2005, about when the mortgage market was breaking historic relationships of income and equity to loan value, accompanied with degradation of underwriting standards, I think.
Since the banks were unable to monitor the quality of these credits independently (remember Warren Buffet talking about how a derivative would be made up of pieces of hundreds of individual issues, each of which had a prospectus of hundreds of pages, meaning that he could employ a thousand Einsteins to spend their lives reviewing these things and still not get his arms around them), your point about the quality of the sliced and pooled instruments being a mystery to everyone can’t be doubted.
As to what changed ~2000, I think it’s clear that the housing boom created enormous profit potential for the ratings agencies to put their imprimaturs on these instruments, whether they had the ability to analyze them or not. Increase in the money supply, foreign financing of our debt, and cheap imports holding down inflation, are all, I think, uncontroversial contributing factors. So I’d say it’s a matter of stresses to the structure of these markets and entities rather than some fundamental change.
Thanks for the response!
Streetwalker: Calm down, read charitably. I meant to say that it was not (and still is not) widely known that the ratings that Moody’s et al. sell are legally protected from competitors, rather than being, as from the beginning of the 20th c. until the 1970s, protected by the unfailing reputation of the ratings not to underestimate risk.
If this were widely known among investors, then the institutional investors (let alone retail) would not have put any store in the ratings–as last Sunday’s NYT shows that they clearly did.
Many errors in the Waldmann piece.
The investment banks have been subject to basel II since 2005,
["Since April 2005, Goldman Sachs has been subject to consolidated capital adequacy requirements based on Basel II, supplemented by additional capital requirements"] (see link below).
They were not obliged to do so but if not their european operations would have been regulated by EU law, a deal was struck with the SEC and the investment banks are treated as “Consolidated Supervised Entities” by the SEC, this means they follow and report capital according to basel II with some small modifications using the IRB not the Standardized approach with mathematical models approved by the SEC, and they do not rely on ratings agencies but on their own assessment of credit risks.
There is no question that that setup resulted in sharp cuts in regulatory capital as of mid-2005 and a huge increase in leverage, all approved by the regulators.
The rest is history, of the 5 investment banks with EU operations registered as CSEs none if left standing as an IB.
quote from goldman letter to the basel committee
http://www.bis.org/publ/bcbs14041/ca/gs.pdf
“why did something that worked great for more than 30 years thru various conditions suddenly fail?”
Some possibilities:
1) Securitization works well. Subprime mortgages don’t. The use of subprimes in MBSs was a new phenomenon. Subprime mortgage loans also have some weird optionality that makes them unusually sensitive to housing prices.
2) Securitization never worked. It just took the right kind of economic conditions for them to fail. This happened to S&Ls when interest rates rose even though the S&L model kind of worked for a while.
3) Something (i don’t know what) drove very high demand for risk free securities and this drove wallstreet to find new ways of supplying risk free securities with higher yields. This demand combined with greed drove the creation of more and more MBSs. The original MBSs made sense and were reasonably valued. The new ones based on subprime loans, CDO squareds and synthetic CDOs were not. Investor demand and financial innovation led to the creation of these new instruments. The real question then is what drove investor demand?
@Jeffrey Friedman
I don’t have the pleasure of knowing you, so I cannot say this with certainty but let me assume you are not familiar with the Street – what little if anything is left of it. Questions about the rating agencies date back to Enron, but it took a long time to get investigations opened for mortgage concerns.
You cite an article about 6 months old. In the context of the Street, where execution is measured in 10ths of a second, where access to the gateway is all, where S&P was rating billion-dollar deals in 90 minutes, 3 months was an geologic age. April sounds like the Mezozoic.
When you play at this level, you have to move much faster – if I had been a risk executive, by June I certainly would have taken a fresh look at those structures I was involved in and started unwinding deals. The market just isn’t for the slow: He who hesitates is slain.
But surely “Flip This House” was the Joe-Kennedy-meets-the-shoeshine-boy moment, yes?
Lovely talking to you as always.
Hmmm. It seems that a more accurate term would be the Master Baiters (and Switchers) of the Universe.
I think you have hit the nail on the head when you mention “legally protected oligopoly,” and not just re the ratings agencies. Try the entire financial system. “Too big to fail:” what, is that an accident of nature? Give me a break. The problem with oligopolistic collusion aka cartels is the temptation to defect. Without a means to *enforce* the collusive agreement, the cartel will not endure. Enter Uncle Sam, the mechanism whereby defectors may be punished… notice that I said defectors, not the cartel itself. You can analyze this regulation or that one, by you will always be a day late and a dollar short. For proof of this you need only observe that “too big to fail” policy has only resulted in fewer, bigger players, an obvious paradox at face value.
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