Risk Mis-Assessment Agencies

No real surprises here. One of the reasons financial markets faltered is that ratings agencies fell down on the job, in large part due to the presence of incentives that worked against issuing low ratings:

Study Finds Flawed Practices at Ratings Firms, by Michael M. Grynbaum, Commentary, NY Times: The analyst at the credit ratings agency was blunt: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

That candid assessment, sent by e-mail to a colleague in December 2006, referred to the market for certain investments linked to subprime mortgages — investments that were assigned top AAA ratings from major agencies, only to later plummet in value.

That e-mail message and dozens like it were disclosed Tuesday in a blistering 37-page report issued by the Securities and Exchange Commission, which confirmed what many on Wall Street had long suspected: the major ratings firms, including Fitch, Moody’s and Standard & Poor’s, flouted conflict of interest guidelines and considered their own profits when rating securities, among other suspect practices.

The report represented a definitive dent in the aura of objectivity that has been cultivated for decades by ratings firms... The assumption was that the firms’ analysts — ostensibly disinterested types who assess the financial health of everything from states and cities to complex mortgages — offered a bias-free view of potential investments.

Instead, the S.E.C. found that the agencies had become overwhelmed by an increase in the volume and sophistication of the securities... Analysts ... began to cut corners. ...

The report also turned up evidence that ratings firms had run afoul of basic guidelines intended to avoid conflicts of interest. It is common practice for investment banks and other financial outfits to pay agencies to rate assets they will later sell. Agency regulations often require analysts ... to remain unaware of any business interests involved with the products whose safety they are gauging.

The S.E.C. found that this was not always the case. ... For example, in an e-mail message from November 2004, an analyst wrote that he was unsure of providing a particular rating because it could hurt revenue. ...

The agencies also considered changing their ratings criteria to better compete with their rivals. ...

The S.E.C. also found that the agencies did not sufficiently disclose or document changes to their ratings criteria. ...

It was unclear whether the findings would lead to criminal charges against the agencies. ... The findings from Tuesday’s report would have to be referred to the enforcement arm of the S.E.C. before any charges can be filed, a spokesman said.

Some states have already opened investigations into the agencies’ conduct. Last week, Moody’s acknowledged that some employees had gone astray of internal conduct codes. ...

Comments

[Lafayette]

Economic cycle momentum

Starting from the 1980s, when Europe was sitting comfortably behind its Common Market tariff barriers, its citizens (VERY ignorant of economics) decided that their sort of cocooning would or should last forever.

One must consider the underlying circumstances of the period in question. Europeans were living in essentially protected economies for two reasons -- tariff barriers (both official and officious) and the Iron Curtain (that impeded the competitive supply of labor). Some call this "cocooning".

The West, in the early 1990s, demonstrated courage in seizing the moment. It saw, under Gorbachev, that the totalitarian underpinning of Russia was crumbling and deduced that China's might not be far behind.

So, it incentivized both countries, by means of the GATT negotiations that opened both to World Trade and Commerce, to induce them out of Communism and into mainstream Capitalism. The ruse worked -- for them, not necessarily for Europe.

Europe was in very bad posture regarding productivity. Post-war productivity figures for Europe were looking pretty good during the period starting from 1960 up to 1980, or so. But, after 1980, employment went to hell in a hand-basket. Something happened. Cocooning was reinforced as people became addicted to their leisure time off.

Continental Europe unemployment figures ratcheted upwards to between 8 and 12% (depending upon the country) for almost a quarter of a century well into the new millennium. It is only recently coming down, grudgingly.

People on the dole, don't spend -- that's an axiom. Furthermore, when the GATT reductions in tariff barriers arrived, Communist China was lured into the world market for cheap goods. This inflicted further damage to the lower un- and semi-skilled labor markets, since this class of labor did not have the skills necessary to access jobs in markets where production was not dislocatable. They obtained lower paying work and continued with a sub-standard of living.

Furthermore, both powerhouses, Germany and France (but Italy as well) were still cocooning well into the new millennium, thinking that low annual hours-worked need not change. This torpedoed their productivity (in terms of output per hour worked). To this day, the French workforce still remains highly attached to the 35-hour work week, blithely overlooking the damage it does to both productivity and therefore wealth generation.

But, we don’t expect ordinary people to understand such nuances, should we?

The introduction of the 35-hour week in France was pure folly. The rest of Europe was not all that better. One need only look at some of the annual hours worked, from OECD data (2004):

France: 1543
Germany: 1440
Sweden: 1584
Spain: 1632
Netherlands: 1404
Euro-zone 1592
Czech Republic: 1962
Japan: 1789
Korea: 2394
North America: 1757
Mexico: 1848
OECD: 1753

It is axiomatic that work generates personal disposable income, which fuels demand that creates work (and employment). Therefore, the more one works, the more wealth should be generated – all other things being equal. But, all-other-things are NOT equal, are they?

A country can certainly decide that it does not want to enter the rat-race of "all work and no play that makes Jack 'n Jill" dull people". But, then, neither can it aspire to a standard of living that Comparative Laziness will afford it.

An economy is like a kid rolling a bicycle tire along a road. Children know intuitively that to prevent the wheel from falling over, they must maintain forward momentum and avoid the pitfalls.

Pitfalls are the famous "externality factors" that Economist employ when a neat little scenario that describes a stable economic situation suddenly falls over. Vicissitude is an inherent factor in any economic cycle. It can be planned for but rarely avoided, despite the best of our intentions.

More important, I suggest, is maintaining momentum. How's that?

Economic momentum is the ability of an economy to sustain (and increase) the production of goods and services at equilibrium prices for a given population. Key word: Sustain. An economy sustains output when it fully employs its population at labor rates that permit personal disposable income beyond non-discretionary and on to discretionary spending. Non-discretionary income is spent on the basic needs to survive – such as food, shelter. But, is that enough?

I submit that disposable income that sustains a standard of living without enriching or enhancing it may be necessary but insufficient for economic growth. (And, I suspect that this was at the heart of the inevitable implosion of the communist planned economy.) I submit further that discretionary income induces people to purchase goods and services that are beyond mere sustenance living.

Such expenditures provoke a desire for new/better products and services, which "sustain" the economic cycle momentum by pushing it forward and upward.

NB: Yes, there is a role for equilibrium prices to play. But, that’s another complex subject …

[a]

"...many on Wall Street had long suspected..."

"knew" would be more accurate.

[Independent Accountant]

Big deal. The SEC has had 31 years to clean up the CPA profession and accomplished nothing. The rating agencies problems are the same as CPAs, i.e., the classical agency problem. The SEC will have no more success here than it has had with the CPA industry.

says...

a says...
"...many on Wall Street had long suspected..."

"knew" would be more accurate.

Indeed.

Quasi-governmental power. Zero accountability. Let's hope we recall this episode next time we hear talk about how "independent" third party certification makes regulation of finance, drugs, food, consumer products, etc. more efficient. Oh yeah, Enron was supposed to do that...

[hari]

The EU/Ministers of Finance decided last week (Lux) to demand full registration of Rating Agencies under EU laws. There is adequate evidence, so far, collected by EU officials to demonstrate collusion between investment banks and rating agencies specially on SIVs and CDS (swaps).

This is going to turn out to be a very messy business if Bush stayed on (for a third term/McCain?) or preferably BO took over the issue of SEC regulatory regime and its efficacy (eg. SIV, CDS, etc).

BB/Fed is already trying to prempt the issue before it becomes a political baloon here, in EU.

[bakho]

Shorter version of the problem.
Lying for personal gain.
No penalties for lying.
Liars bilk the system.

[Mark]

No doubt, a great deal of sins of commission. However, the quotes from the internal emails also reveal a more systemic problem with regulating the entry of products into the marketplace. Whether the product petitioning for market entry is an innovative financial instrument, a new drug or medical device, a new industrial chemical, or a newly imported commodity that could introduce an agricultural pest or disease, there are inevitable pressures on the licensing agency to hasten the pre-market review process and grant approval under high uncertainty about the likely risks and returns.

[Regulation Hell]

Regulation naturally produces a snake pit of such conmen. The more complex the system, the more opportunities to game the system.

It's an illusion to think the authorities can regulate complex financial markets. Only severe punishment (big failures) would give market players pause. Now even that is off the table. Party on, dudes. Helicopter Ben to the rescue.

[macburger]

Bernanke's bailout of his buddies continues. The Wallstreet pigmen make the profit, and the public bears the loss.

Bernanke is a crook, through and through.

http://www.ft.com/cms/s/0/e55e15f0-4db1-11dd-820e-000077b07658.html

..on Monday, with the support of the Treasury, the Securities and Exchange Commission and the Fed signed a memorandum of understanding that, in effect, puts the key elements of a Fed regulatory structure – and implicit Fed backing for the large investment banks – into place. What this amounts to is a straightforward Fed reach for important new regulatory authority, an unprecedented step in which a weak SEC – chastened after the failure of Bear Stearns – has been complicit. It would be perfectly acceptable if the agreement covered only the emergency period the markets are now experiencing, but it has no time limit.

The agreement is very bad news for US taxpayers. Fed involvement with the regulation of investment banks will introduce moral hazard into the securities business for the first time and pave the way for a vast new US government liability. The agreement between the Fed and the SEC will seriously compromise market discipline, which only exists when creditors and other counterparties believe that they are financially at risk. What now amounts to ongoing supervision of the financial condition of investment banks by the Fed sends an unmistakable signal to the markets that the government believes itself to be at risk. Under these circumstances, investors will be justified in believing that the US government will ultimately stand behind the large investment banks. This will irretrievably compromise market discipline, which in turn will produce the very risk-taking and subsequent losses that regulation – as recently as the savings and loan debacle – has never been able to prevent.

[Patricia Shannon]

Regulation Hell says...

Regulation naturally produces a snake pit of such conmen. The more complex the system, the more opportunities to game the system.

It's an illusion to think the authorities can regulate complex financial markets. Only severe punishment (big failures) would give market players pause. Now even that is off the table. Party on, dudes. Helicopter Ben to the rescue.

So you think that conmen wouldn't make sure they came out in good shape? Do you think all conmen are incompetent?