Tuesday, December 16, 2008

Substituting One Problem for the Same Problem...

Eric Martin's recent post The Open Road to Serfdom suggests that regulations that would reduce the conflict between issuers and the ratings agencies is "a good to place to start". A post by Matt Yglesias suggests that it makes a lot of sense to consider a public agency that rates fixed income instruments. Matt's justification for a public ratings agency is as follows:

All of which is a long-winded way of saying that it would make a lot of sense to try to develop a public agency that rates credit instruments. Wouldn’t stop anyone from relying on private sector ratings if they wanted to. Nor would it guarantee that the public agency would always get things right. But it would provide a check on some of the distortions that the current system produces.

I don't necessarily agree. Yes, the agency-issuer conflict was, I believe, a factor that led to some of the more serious problems in the capital markets, but this was not the only contribution to the problem given to us by the ratings agencies. There were two others:

1) To paraphrase Roger Lowenstein, the ratings agencies were using 100 years of historical weather data in Antarctica to forecast the weather in Hawaii as far as rating mortgage backed securities. Nothing in the historical data could have addressed the then-current lending environment. Furthermore, nothing in the historical data could have given any warning signs to the trouble that was to come. Am I to believe that a public ratings agency, given the same data and, most likely, an underwriting methodology not dissimilar to what a Moody's would probably do would have been able to accurately rate these securities?

2) The increased complexity of exotic structured finance products like mortgage-related collateralized debt obligations presents a signficant knowledge problem for any ratings agency that is tasked with having to rate them. In these situations, the people that would be the best help to those analysts responsible for understanding them would be the underwriters themselves. In a real-time, fast-paced capital markets environment where everything has to be done yesterday, who else are the analysts going to reach out to? Assuming a public ratings agency was to rate mortgage CDO's, how would the process been any different?

I think difficulties in dealing with an ahistorical situation in the market, rating complicated structured finance products that, in hindsight, clearly did not understand combined with the relationship between the issuers and the ratings agencies all played roles in this situation. With respect to (1) and (2), while I am not suggesting that the ratings agencies were afflicted only by bad circumstances (there are steps they could have taken especially with due diligence and document verification), it is not clear to me how these "current distortions" could have been mitigated by a public ratings agency.

Even if a public ratings agency would, in effect, directly eliminate any conflict between issuer and ratings agency, it would be incredulous to believe that a public ratings agency would not be subject to the same sort of pressure from politicians, lobbyists and interest groups, all of whom are looking out for the interests of their own respective factions. Like any regulatory body, this agency would not turn out to be some neutral, virtuous gatekeeper who will only keep market participants in check but rather another regulatory body that will ultimately be influenced by those it is supposed to keep in check. Eric may want to believe that such a thing is the modus operandi of the modern GOP. I respectfully disagree. This is the modus operandi of government. Whether it is the Securities and Exchange Commission today or the Interstate Commerce Commission of 100 years ago (as documented by Milton Friedman in Free to Choose and Capitalism and Freedom), the story is the same.

Personally, I think the ratings agencies may have made the mother-of-all-screw-ups or something close to it. That said, I am not convinced that had a public ratings agency been in place, the crisis would be any less than it is. I am also not convinced that the appropriate response is a public ratings agency for the reasons I mentioned above.

As a final note, all of what I wrote above ignores two other considerations which I don't spend a lot of time addressing and will only mention here: 1) the fact that the ratings agencies cover a lot more than mortgages and nothing of this magnitude has reared its ugly head elsewhere, which may suggest that the agency-issuer conflict with respect to, say, municipal bonds, isn't as much of an issue; and, 2) indirectly addressing a question posed to me in a previous post, the public debt markets that were dependent on being able to successfully sell mortgage backed securities have shut down. Investor demand is nonexistent and origination volume is next to nothing for the year. Furthermore, for a lot of reasons, some having to do with basic market principles and others a revamped regulatory environment, it is very, very unlikely that this anomoly in the capital markets will rear its head again for a long time, if ever.