Taming Rating Agencies

Dr. Kurtulus Gemici*


Alchemy thrived in seeking how to turn ordinary, worthless metals into gold. To the dismay of countless alchemists,  that  goal  has been rather elusive in the world of metals. Not so in the world of modern finance. The business of making golden assets out of worthless ones, a relatively recent innovation, has been a particularly lucrative practice in financial markets. The name of this game is structured finance and securitization . It uses the tools of modern finance to transform highly risky or junk assets into something shinier. Once these securities receive good ratings from institutions such as Moody’s or Standard & Poor’s, they become legitimate investment instruments that can be used in all types of financial transactions. This is, then, the alchemy of contemporary finance: converting assets once considered unacceptable for financial transactions into prime investment commodities. There is a growing consensus that this alchemy was a crucial element of the financial boom—so much fool’s gold— that ended with the meltdown of the world financial system between 2007 and 2008.

the financial meltdown of 2007-2008 was at least partially a consequence of deregulation and lax supervision…”

Convinced that the financial meltdown of 2007 -2008 was at least partially a consequence of deregulation and lax supervision, American politicians are eager to pass legislation to curb the power of financial markets and its institutions. A new amendment to the financial regulation bill, proposed by Sen. Al Franken and approved in the Senate on May 13, aims to limit the considerable influence a handful of agencies exercise over credit ratings. The central idea is to establish a board, consisting largely of private investors, to determine which agency would rate newly issued asset-backed securities. This regulatory entity, named The Credit Rating Agency Board in the amendment, will also supervise the performance of rating agencies. The avowed goal of this legislation is to put a stop to the practice of inflating ratings on securities backed by assets such as house mortgages.

It’s a nice idea. Establishing a Credit Rating Agency Board might perhaps address conflicts of interest, collusion, and corruption in the business of rating credit and financial instruments. However, conflicts of interest and collusion are not why sophisticated rating agencies such as Moody’s and Standard & Poor’s handed triple A ratings to financial instruments consisting of a pool of subprime mortgages, and why such ratings turned out to be poor assessments of credit quality. Rather, rating agencies believed they could mitigate risk through the application of their own alchemist’s formula: they would use the knowledge and tools of financial engineers, academicians, and bankers to transform highly risky and dangerous financial instruments into risk -free ones through the precise measurement and quantification of market uncertainty.

Securitization is the primary tool through which financial market practitioners engineer high-quality financial instruments out of assets such as subprime mortgages. This practice involves pooling risky assets and then slicing this pool into different tranches. Each tranche is endowed with different rights about the cash flows originating from the asset pool, meaning that the risk of default is distributed unevenly among different tranches. While equity tranches bear the risk of the first three to six percent of defaults, senior tranches are protected from a large percentage of de- faults. As a result, each tranche gets a different credit rating, creating the opportunity to obtain triple A instruments even from assets that are considered to be be- low investment grade.

Securitization, as a tool in financial engineering, involves specific assumptions and projections about the housing market and how defaults in underlying mortgages occur over time. It requires knowledge necessarily probabilistic about the per- centage of mortgages that will default in the future. Most importantly, it involves assumptions about the percentage of defaults that are likely to occur at the same time. If a large percentage of the assets underlying a securitized financial product default simultaneously, even the senior tranches are not effectively protected from the default risk. That is indeed the moment when the logic of securitization fails miserably, with the implication that the ratings accorded to different tranches become erroneous. That is exactly what went wrong with the rating agencies before the meltdown of 2007 -2008. Ratings institutions assumed

“…there is no viable alternative to sweeping cultural change in finance.” 

that housing prices would rise forever and miscalculated the risk of simultaneous defaults. In the meantime, by contributing to the creation of vast amounts of credit and leverage in the financial system, they enabled the inflationary spiral in the housing sector. What failed them was the particular culture assumptions, expectations, knowledge set, toolkits, and mathematical models through which they assessed risk and uncertainty in financial markets. That is why legislation aiming to stop corruption and conflict of interest in credit rating agencies is not sufficient to stop inflationary ratings of essentially risky assets.

Once considered the darlings of Washing- ton and the source of indisputable wisdom, financial markets and their institutions are again les bêtesnoires of politics. This political environment creates the opportunity structure for the re -regulation of financial institutions and markets, which is a much – needed and belated adjustment in the relationship between finance and society. However, such an adjustment should be efficacious in the long run. And efficacy in the long-run necessitates broad changes concerning existing tools, assumptions, expectations, and models employed in the world of finance. That task is, of course, considerably more taxing than establishing a regulatory board charged with supervision. Alas, there is no viable alternative to sweeping cultural change in finance. Otherwise the current reform and reregulation movement will simply miss the target, and financial engineers will once again assume their roles as modern day alchemists. Until the next explosion.

Note:
* Kurtulus Gemici is a Visiting Scholar at New York University.

 

 

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