The Rating Agencies

One way to carve up the categories of failure of past and continuing financial regulation is complexity, conflicts, and complacency.  That’s taking cupidity for granted.  The rating agencies appeared to offer a way to outsource the agency problems inherent in investors seeking to evaluate complex financial instruments that, in any case, trucked in assets a long ways from the ultimate investors.  It didn’t work so well – the rating agencies both participated in and ratcheted up the already-existing tendencies to greater complexity of instruments, ever deeper conflicts of interest among players, and especially a tendency to complacency about the other two on the part of everyone else.

Everyone knows this by bitter experience now, of course, but the problem is, what to do about it.  The Economist has a short and informative article on the on-g0ing debate concerning the role of the rating agencies, with respect to corporate debt (the original product), complex financial instruments (whoops), and sovereign debt (hmm …).  The main questions in the article are about whether and how to sever the “opinion” role of rating agencies from their current “outsourced gatekeeper” role.

By the latter term, I mean the role that regulation in the US assigns to selected rating agencies (effectively the big three) by using them as official proxies for (non)-risk.  The creation of official proxies both leads to cognitive failures, as investors instead opt for the ratings in lieu of their own assessments, and to regulatory arbitrage, as investors implicitly figure that if enough investors have relied upon officially sanctioned ratings, then they are effectively offered an official guarantee.  There is general agreement that the rating agencies should be shunted back into the merely “opinion” role – though that role is weightier than “mere” opinion sounds, given that these opinions have not just a regulatory assignment but a private contractual one in so many contracts.  Easier said than done:

Unfortunately, finding alternatives to ratings is proving difficult. Some suggest using credit-default-swap prices, but these too can exacerbate market swings. Others propose a minimum volume of past debt issuance, but this discriminates against smaller entities. Regulators remain open to suggestions for how to assess risk in bank-capital rules without ratings.

I understand the article’s point – particularly that credit default swaps are useful instruments so long as they are not the sole, effectively tautological, mechanism assessing risk – but think it slightly misstates the issue.  The problem is not so much how to get by without ratings, but instead what methods should be applied to reach whatever conclusions are reached, whether expressed as ratings or analysts’ reports or any other way.  In the case of corporate bonds, the risk-rating methods of the agencies have worked reasonably well, are well understood, and those using those conclusions can, if they really care, run the analysis themselves; that’s a question of trusting not the method but the agency to diligently carry out a method that is widely accepted.

In the case of complex financial instruments, no such confidence exists in either the methods or the agencies.  Every serious financial journalist I’ve read, examining the role of the agencies in the run-up to the crisis, treats the agencies as not having understood the instruments, let alone the models proposed by the banks for measuring their risks; those ratings were not proxies for knowledge but instead proxies for government guarantees.  What matters is agreement on the methods and agreement that whoever is assessing the risk applies them adequately; the rest is simply how complex or simple the expression of those conclusions in the markets.

In the case of sovereign debt, the article says that ratings have been reasonably good at predicting sovereign default:

On the debt of countries, however, their record is considerably better. In a study last year, the International Monetary Fund concluded that ratings were a reasonably good indicator of sovereign-default risk. All countries that have defaulted since the mid-1970s had their grade cut to junk by ratings agencies at least a year beforehand. In the current European crisis, ratings firms had begun to downgrade peripheral euro-zone countries years before bond markets woke up to default risk.

This is right as far as it goes, I suppose, but I have reservations that it will work so well in the global financial environment emerging now and running into the next ten or fifteen years.  Rating agencies might well have problems anticipating, for example, issues with the hegemon-in-decline, still the issuer of the world’s reserve currency, but engulfed in gyrations around its own unsustainable debt path and liable to political and monetary actions by its government and central bank.  They might also have problems anticipating issues with a sui generis creature such as the Eurozone, with its fractured monetary and fiscal authorities, its untested and unfinished supranational political structures.  They might have problems figuring out the far-from-transparent balance sheets of a China, India, or Brazil.

I doubt this is a smoothly marginal world, in other words; balance sheets rise by asset and instrument, but collapse by institution.  And in those environments, the “at least a year” that the Economist mentions seems to me cold comfort if we would like to see any possibility of an orderly unwinding of market positions in fantastically large quantities of sovereign debt.  Where’s it going to go, anyway?  The political structures and sheer size, political and economic, at issue in today’s markets are not as they were for the sovereign defaults (Argentina, etc.) that the Economist seems to have in mind.

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