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All posts by Dan Whalen,
Providence, RI (resume)

Friday, February 8, 2013

The Fed's S&P lawsuit

Why does Amazon let users review products?

Let's say your looking to buy a car, or a computer or a house.  It’s a big investment, so you want to be sure you’re getting your money’s worth.

But you don’t know much about the item your about to buy.  You have no idea how much RAM you need, or for that matter how to find out how much RAM the computer has, or for that matter, what RAM is.  You don’t know the repair history of the car, or whether or not that roof is as shoddy as it looks.

So what do you do?  You ask someone who does know.  You read the reviews on Amazon.  You pay an appraiser or a mechanic to give you the honest-to-God story on the items merits and value.  The info they provide can help you decide whether or not the deal is any good.

An expert’s opinion can clear up the information asymmetries that put kinks in the market.  If you don’t know what you’re buying, you don’t know if it’s a good deal.  The buyer needs to know what they’re getting themselves into to be sure they’re using their money wisely.


What is a rating agency?

The global banking and financial industry is complicated.  Like really complicated.  It’s a huge interconnected set of systems, each with their own rules, regulations, advantages and weaknesses.  

Financiers are professionals that learn to navigate this system, and study all the steps to its byzantine dance.  But they have the advantage.  That’s all they do.  It’s what they do.  So they're probably better at it than anyone else out there.

The rest of us - those outside the financial system, but interested in getting into it – would feel hesitant to just dive in.  So we hire a guide.  We give our money over to banks, or trust our savings to financial brokers.  And what do they do with our money?  They invest it as they see fit on out behalf.  

And how do banks, financiers and investment professionals determine how to invest your money?

That’s where it gets tricky.  On the small scale, these decisions are typically handled entirely within your bank.  Your local banker has made loans to every shop in town at one point or another.  Your neighbor’s mortgage was probably financed by the same broker that will finance yours.  

They really are experts on the local economy.  They understand best the simpler, straight-forward, small scale stuff.

But what about new types of investments?  Or ones that aren’t strictly local?  What about financial vehicles that are connected to multiple industries, or are influenced by events and regulations all over the world?

When bank’s themselves aren’t sure whether or not something is a good investment, they turn to what are called “rating’s agencies” to get that “expert evaluation.”  A rating agency is a company that examines big or new financial investments and lending deals.  They try to determines how risky they are, and how much wealth they stand to generate.

Houses have real estate appraisers, restaurants get their Michelin stars, and financial investments have ratings agencies.  Its an entire profession dedicated to measuring the risks and values of investments.  

Should I put my savings into stocks or bonds?  Should I trust my retirement funds to mortgage backed securities?  Can we safely hedge our risk through credit default swaps?  Ask the ratings agencies.

Who are these rating agencies?

These rating agencies function like advisers to banks and investment firms.  And because most of us are not banks and investment firms, the name Standard and Poor's (S&P), Moody’s or Fitch aren’t really household names.

But these “big three” companies have huge amounts of influence in the global financial system.  I don’t care where you live in the world, your bank reads these guys’ reports.  

Their opinions are the benchmark, the norm, the conventional wisdom when it comes to evaluating super-large scale investments.  Like the kind of multi-billion dollar investments that a Bank of America or an HSBC or an M&T might be making.

Ok, but so what’s wrong with that?  Your bank, your broker, or any Warren Buffet sized individual investor, they have to make tricky choices too.  They too are studying the information available, and constantly making what they think is the best move given the circumstances.  How is the local bank, mortgage broker, or money lender any more entitled to their opinion than these rating agencies? 

I mean, S&P, Moody’s and Fitch are full up with thousands of people who are just as smart, then the guys who work at your local bank.  Their estimation as to how the investment is going to work is as good as any other’s, right?

Well, in most cases, I’d say so.  When it comes to something like a simple company bond, or stock, or a 401(k), or IRA, they’re the golden child.  Evaluating these simpler items is a pretty straight forward process.  Not as many imponderables.  You don’t need to be an expert mechanic to understand the difference between an aging Civic and a new Mazda.  We don’t call in the appraisers to tell us if the ramble-shackle, no window, rotten porch house is really worth $100k.

But what about when it comes to something new, or complex?  Like a mortgage back security, or some kind of collateralized debt obligation?

The ‘housing bubble’

In the late 1990s  to early 2000s, banks became very reliant on ratings agencies to determine the value of derivative investments, particularly ones connected with real estate and housing. 
 
Many of the big rating agencies gave these puppies enthusiastic endorsements.  Only a few years later, they had all crashed and burned, and set off the chain reaction that gave us the financial crisis.

Were the endorsement an honest mistake?  A lot of assumptions and tricky estimations went into them.  And a lot of folks outside the rating agencies also seemed to think MBSs were a sure bet.

However, there is an odd incentive for raters to give good reviews of investments.

Ok, say I have an investment opportunity.  I need to find some folks to pitch in money on it.  I need some investors. 

If I tell investors “My idea is great!  It’s a sure fire money-maker!” they’ll be a bit skeptical.  Of course I think its great – I created it.

So I’ll go to a rating’s agency to see if I can get an "impartial professional" to verify my assessment.  There’s several ratings agencies I can go to in town, and I have to pay a pretty penny for their services.

There’s a suspicion going around that at some point the rating agencies started making their assessments extra enthusiastic, extra positive, as a way of competing with each other, and attracting more business.

Where the rating agencies motivated by profit to overstate the effectiveness of the financial vehicles?  Where they honestly duped?  Where the derivatives simply TOO intricate for anyone to know what the risks were?

The US govt has just announced its slapping S&P with a lawsuit over the whole thing.  They contend that S&P deliberately gave good ratings to housing derivatives to attract the business of those dealers looking to promote those derivatives.  

S&P got singled out because they were a little more involved in the housing derivatives, as well as a bit more enthused about them.  Its like the govt is accusing S&P of being really good at what they do, and S&P's defense is that they aren't.  Which is weird.

What the govt will have to prove is that S&P intentionally inflated their ratings, even though they understood how risky the housing securities were.  S&P will have to make the argument that it really made an honest mistake.  Its will be an interesting lawsuit.

For me, it all comes down to how scientific an industry investment rating is (or how scientific it fancies itself to be).  

When you fail to rate an investment correctly, is the proper parallel doctor committing malpractice, or an appraiser neglecting to get into the basement to look for cracks in the foundation?  

Or is it more like a movie critic giving a good review to a honestly horrible film?  Or a sports commentator failing to accurately predict the outcome of an upcoming match?

My opinion is that it really depends on the investment itself.  I think there’s a pretty straight forward, objective way to look at a bond, or a futures contract.  But when it came to the MBSs, CDOs and CDSs that got us into this mess, there’s too many predictions and assumptions that go into it.  In these cases, rating agencies are more of a foretuneteller or soothsayer then an real objective assessor.  

Either way, it’ll be interesting to see how this all plays out in the trial...

1 comment:

  1. Great post, although I disagree with the last point. The more complicated the asset, the more you need good models with updated unbiased parameters. My solution to the rating agency problem is greater reliance on transparent, open source models. See http://www.expectedloss.blogspot.com/2013/02/the-s-lawsuit-can-it-fix-rating-system.html

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