With the Dow's introductory curtsey below the 13,000 mark this morning, the wild swings in the market of late seem to merit comment. The Wall Street Journal obliges with its lead today, a piece -- under the witty (dare I say, Murdochian?) caption, "Credit and Blame" -- pointing the finger at S&P, Moody's, and Fitch. The agencies "gave top ratings to many securities built on the questionable [subprime] loans, making the securities seem as safe as a Treasury bond."
As we did on last night's Marketplace, I suspect we'll hear a good deal more in the coming weeks and months about the incentives and compensation structure of the ratings industry:
The subprime market has been lucrative for the credit-rating firms. Compared with their traditional business of rating corporate bonds, the firms get fees about twice as high when they rate a security backed by a pool of home loans. [W$J]
And who pays that fee? The banks and mortgage companies who create the products. And when an agency won't render a positive rating? Customers can "take their business to another rating agency." [W$J]
This symbiosis of rater and rated is reminiscent of the mutual fund problems that flared up in 2003. Lipper and Morningstar purport to rate, recommend, and supply "leading fund intelligence" on mutual funds, but critics like David Swensen note that their system is retrospective and largely useless as an aide in forecasting: e.g., tech funds received middling grades in the mid-nineties (just before their historic run up) and spectacular grades at the millennium (just before their historic crash).
Of course, even law schools ask the graded to pay the graders -- with what some see as a concomitant increase in the rosiness of the ratings (i.e., grade inflation) -- so perhaps this problem is impossible to avoid. Or can we ask employers to pay universities to grade potential hires?
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1. Posted by Michael Guttentag on August 15, 2007 @ 19:50 | Permalink
Are we to believe that hedge fund managers were not smart enough to understand the incentives that Moody’s and S&P were working under? It is one thing to assign some responsibility to Wall Street sell-side analysts in the context of individual investor investing during the dot com boom, but the story seems less believable in the context of hedge funds. This seems particularly the case when the risks in the sub-prime market were pretty obvious (see, e.g., Elizabeth Warren, Robert Shiller). It is going to be interesting to try and explain substantial hedge fund losses in the mortgage market, since neither agency costs nor lack of sophistication are obvious explanations, but I don’t think Moody’s and S&P are a big part of the explanation. Probably, like LTCM, the answer has more to do with hubris and an inability to truly understand what quantitative analysis does and does not address well.
2. Posted by M. Hodak on August 15, 2007 @ 20:19 | Permalink
It seems less believable only if you believe that most hedge funds represent "smart money."
3. Posted by Jake on August 15, 2007 @ 22:04 | Permalink
Like Yogi Berra said, "this is deja vu all over again." When S&Ls controlled mortgage lending, they succumbed to the same moral hazards that the less regulated subprime lenders fall prey to today.
4. Posted by Vic on August 15, 2007 @ 22:14 | Permalink
No agency costs in hedge funds, Mike? The carry gives substantial upside to fund managers but little downside risk. This is somewhat balanced by the desire to hold on to the stream of income from future management fees (if the fund does badly, investors may redeem their shares), but still, there's an incentive to take on more risk than investors would like.
In any event, I share your puzzlement at the heavy losses by the quants.
5. Posted by Christine on August 16, 2007 @ 8:36 | Permalink
Back in the mid-1990s, when we were securitizing everything with any semblance of an income stream, the partner I was working for said, "What we have is smart money chasing bad paper." It is Deja Vu all over again.
But I agree that most people have known that bond ratings are negotiated for a long time.
6. Posted by Michael Guttentag on August 16, 2007 @ 14:32 | Permalink
Vic, you are correct: no agency costs would be too strong a statement (if I had said that ;-). I have always assumed that as a fund appreciates, the managers' carried interest is increasingly an in-the-money option. As a result, the fund managers’ payout typically becomes more aligned with fund investors over time. This would be an additional reason that agency costs diminish. Do you think that is true, or do payouts happen every year for most funds? Thanks.