Atlas Shrugged: The Mocking

Thursday, October 8, 2009

Ratings Agencies and Unspoken Goals

Let's start with Megan McArdle's follow-up post to her rumination about the ratings agencies.
Yesterday, I asked what we should do about the fact that ratings agencies were so drastically underestimating tail risk of the securities they rated. Today, Joe Wiesenthal at Clusterstock offers a possible solution....
For some reason McArdle doesn't cut-and-paste most of Wiesenthal's solution. Maybe the reason is that he is simply trying to find a way to avoid regulating something that must be regulated or it will get out of control, as the ratings agencies have. They gave good ratings to junk securities because it was profitable and nobody stopped them. Regulation would be a start to end the ratings problems, but regulation is evil to good little free-market Fairy followers. Here's the rest:
If a debt issuer isn't happy with who they got, then, well, too bad. Over time, you'd give companies that showed a good track record a heavier weight in the pool, so that they're selected more often. Their only goal would be to increase market share by being accurate.Pandering to either buyers or sellers would be 100% impossible.

Now granted, it wouldn't be perfect. Performance measures would be backwards looking, and you'd probably end up with companies that had gotten lazy, and stuck to old ideas about how to rate debt, but that's just life. They'd lose their weighting in the pool, and eventually you could even put companies on probation if they got bad enough.

Nothing's going to change the fact that incumbents grow dumb and slow--but at least they'd have an incentive to avoid that, whereas currently they don't (have the top raters lost any market share? No.)

There's your solution.
[my bold]

In other words, a market that is regulated. My understanding of economics is limited, but if we had regulated the ratings market properly in the first place we wouldn't be in so much trouble now. So I went back and read about six articles on ratings agencies also published on Business Insider, a magazine that tries very hard to live up to its name. The overall goal of the magazine seems to be to discourage any regulation of ratings agencies. From "Don't Blame The Ratings Agencies" by John Carney (a big defender of McArdle):
In a competitive market place, different companies structure their enterprises according to different ideas. In a counter-factual world of openly competing credit advisors, each rating agency would have had to experiment with different theories about credit risk and adjust their theories according the market’s reaction. The process of competition would have worked to produce better ratings by putting the bad credit advisors out of business.

Now it’s very possible that errors in ratings would still happen, and bad ratings companies may even come to dominate for a time because the market mistakenly preferred the wrong rating theory. But a competitive market for ratings would have at least had a chance of producing a better result, and likely would have over the long term.

Isolated from the feedback of the market, the ratings agencies lacked an exogenous indicator about the quality of their ratings. They were left to guess whether or not they were employing the right system, like the socialist shoe maker who just has to guess how many shoes he makes because there’s no price system. Arguments about how to rate mortgage bonds were reduced to just that—arguments that could only be cognitively evaluated rather than tested in the marketplace.

In short, the very laws that protected the ratings agencies marketshare and guaranteed them business, also destroyed the competitive process that could have led to the discovery of better ways to evaluate bond risk. The agencies were victims of the regulatory framework, rendered blind to their own errors.

You see, it was government interference that caused all the problems, not the rampant greed and dishonesty of the Bush Business Philosophy: Give me your money because I deserve it.


Ken Houghton said...

Rating Agency selection, like IPO-issuer selection, was always a matter of LCD.

If you were good enough, you were rated by Moody's/S&P or IPOd by the Giant Vampire Squid.

If you weren't, there was always D&P or Fitch for ratings, or Bear or Citi for IPOing.

Note that there wasn't—and won't be—exactly a diverse market for either (Herfindahl-Hirschman for both activities well in excess of .18.), since the only way to join the market is to be more pliant than the higher-rated ones. (More strict is not a Viable Business Model; no firm would select a new, strict competitor without a Major Incentive to do so. Strangely, neither Mr. Carney or Ms. McArdle sees this as an impediment.)

Euripides said...

What difference does it make that the 'system' the rating agencies had no exogenous, homogenous or even androgynous indicators when the result was always the same? If the result is going to be AAA, no matter what, it doesn't matter in which order you write the 'A's does it?

Also, what the fuck does the socialist shoemaker sentence actually mean? If there is no price system no-one can produce anything? If I ask a friend to bake me a birthday cake they might accidently make a million cakes because they are not being paid for it?

Just how would a socialist shoemaker produce without a price system?

Maybe we should do something really wild and JUST GO TO ARGENTINA WHERE IT IS HAPPENING AND FIND OUT?

Maybe we should not because after the free market clusterfuck in Argentina, the owners of the factories ran off with all the money, so the workers took over, with egalitarian and democratic structures based on mutual aid where things are run for the benefit of the workers, which just proves that it could not happen in the real world, because I have a fancy equation based on myths, and numbers I pull out of my arse, which proves me right, that's why.

If I had to read six articles of such stupidity, I would be a jibbering wreck. (A few paragraphs and now I'm not even sure that I have survived)

I salute your persistance and sanity, Susan. A far braver member of humanity than I can ever be.

Mr. Wonderful said...

Over what time period would these competitive ratings' results appear? The ratings are (ostensibly) to tell investors what securities are worth the risk TODAY. Is this guy suggesting the agencies all take a crack at predicting it, and then everyone come back in what--five years? fifteen?--to see how they did "in competition"?

Isn't that the opposite of expertise and professional competence? "Tell you what, Susan. You go to four other doctors after your checkup with me, and in about five years we'll all see how you are, and you can pick which one of us you'll stay with, based on who wins."

Susan of Texas said...

And if I die in the process I know that the free markets worked?