Rating Agencies on Trial

Something is wrong when an entire industry teeters on the brink of destruction because of - what? - a change in credit rating. Consider the anxiety in and around the monoline insurers. The recent MBIA situation simply brought the point home: investors have given rating agencies too much power. Way, way too much power. Somehow, someway, large swaths of the investor landscape has effectively abrogated responsibility for conducting proper due diligence because an entity which, by the way, is paid for by the issuer, has said "this instrument is ok for investment if your risk tolerance is (choose your letter)." What is happening today isn't unique - we've seen big, discontinuous changes in ratings when a rating agency just got it wrong, was late in incorporating new information, or simply followed the implicit guidance of bond market prices to reassess a ratings stance. And yes, I understand that bond prices and credit risks are not perfectly correlated, and that rating agencies are all about credit risk. But rating agencies remind me a lot of classic sell-side research: take a stance based on the historical information, and only adjust that stance when new information has already caused prices to move. This is not the way it should be. And the markets and investors well-being are in jeopardy because of an excessive reliance on third-party credit ratings.

The very premise of monoline insurers like MBIA and AMBAC has been in question for more than a decade. Minimal capital, massive theoretical exposure, little data on historical losses. It is the classic business of selling out-of-the-money put options, collecting premium, showing great ROE and margins until, POW! You're dead. One of my better posts as a blogger that maybe 3 people read is titled Volatility Management in a Complacent World. The date: April 15th, 2007. World looks pretty different now, huh? It addresses this exact issue, as do about 50 of my other posts about the properties of hedge fund returns, employee incentive programs, and many other financial strategies. So as risks were mounting across many of the instruments backstopped by the monolines, did they alter their strategies, buy insurance, seek to offset a measure of this long-tail exposure? Not really. Here is my conclusion back in April when considering the inertia and idiocy of the marginal risk-taker:

So where we are today is at a time when the costs of insurance are both relatively and absolutely low yet the urge is for investors to sell it, not buy it. Because short-term performance considerations (which directly drive most fund managers' compensation, as well as the ability to gather additional assets to manage) can often drive sub-optimal portfolio decisions. And this is certainly not good for fund investors. And it is at times like these when the smart, savvy, long-term oriented managers with an appreciation for history take a contrarian position. And I might wager that this is precisely what is happening. We'll see the wheat separated from the chaff in short order. Just wait and see.

On occasion, even I can call it. But forget about poor management for a moment. What about the rating agencies? Where were they when it came to forward-thinking in light of new risks on the horizon? I know, I know, they worry about credit and not prices, but don't market prices (after adjusting for interest rate movements) have something to say about investors' perception of credit risk? I'd say so. So if they aren't looking ahead, thinking about future exposures, advising investors of bonds they've rated about their risks in light of new information, then what exactly are they doing? And what exactly are issuers paying for?

Oh, I take that back. I know exactly what issuers are paying for - getting a blessing on their bonds so they can be sold to investors. But what are investors getting out of the deal? Is the imprimatur of a rating agency really worth much? Have they gotten the easy cases largely right and the more complex cases more frequently wrong? And do they only really adjust ratings when it is blindingly obvious that they have to be changed because of information that is already in the market? And who are they ultimately working for? Shouldn't they really be working for the investor and not the issuer? Doesn't this create perverse motives, the exact same short-optionality perverse motives enjoyed by senior managers and others who are incentivized to show "superior" performance, keep things nice and steady, get paid a bundle until BOOM! Game over but they've already gotten paid and gone home? The whole thing is just wrong.

It all really comes back to the same issue: caveat emptor and for gosh sakes, do your job. Especially if you are a fiduciary. You simply can't outsource responsibility for making decisions that are core to your mission. If you are going to invest in complex instruments, do the homework or don't invest. And by all means, do not rely on the opinion of others whose motivations might not be aligned with your own. Because as we've seen, this can result in some very ugly outcomes.

Comments

[druce]

The taxable bond insurance business is pretty much just a ratings scam.

Suppose you're a AAA credit. I'm a banker and I tell you, I've created these tasty bonds, I can sell them as AA, or, how about you insure them for 50bp, and I'll sell them 100bp richer?

Now why would you not say, "yes, those are indeed tasty bonds, so how about you sell them to me at the market rate, and I'll issue AAA debt and capture the whole spread?"

The only reason is that you can't actually issue AAA debt, or more precisely, that the rating agencies let you insure at least twice as much debt as they would let you actually issue. Even though you're taking the same default risk in each case.

It's purely a ratings arb.

(this is on the taxable side - the muni insurance business has a valid tax arb... I can put all my bonds in local entities, and get crushed if there's a hurricane and the local economy tanks, or diversify and lose my tax benefit, or keep local and buy insurance and keep both diversification and tax benefit. Effectively the insurance company is selling diversification and it's a free lunch due to the taxes)

It's a topsy-turvy world when hedge funds are scrambling to review their counterparty risk vis-a-vis banks, as opposed to the other way around.

[Josh Stern]

"The very premise of monoline insurers like MBIA and AMBAC has been in question for more than a decade. Minimal capital, massive theoretical exposure, little data on historical losses. It is the classic business of selling out-of-the-money put options, collecting premium, showing great ROE and margins until, POW! You're dead."

To make the analogy closer, the monolines are similar to a business of selling out-of-the-money European style LEAP puts with settlement dates 5-20 years (picking midpoints of the maturities). That might be a very attractive business if there were a supply of buyers for such contracts.

[Yaser Anwar]

Hello,

Would appreciate if you had any thoughts on Countrywide. Thank you. Y

[STS]

Why doesn't somebody start a rating agency which is funded by the buy side? Maybe call it "Snitch" instead of "Fitch" ;)

[Forest Ranger]

Excellent post...A friend of mine, who works for a leading mutual fund, told me that their fund managers mostly avoided this trap by taking fiduciary responsibilities seriously. They decided to pass on any complex product that they didn't fully understand.