“There are two superpowers in the world,
the USA and Moody’s bond rating division
and it is sometimes unclear which of them is more powerful”
2- I know, right, model definitely does not capture half the risk
3- We should not be rating it
4- We rate every deal. It could be structured by cows and we would still rate it
Financial journalist Roger Lowestein investigated how Moody’s rated CDOs. To preserve confidentiality, the CDO was given the name “Subprime XYZ”. It was a package of 2939 mortgage loans made in the spring of 2006 at a total value of over $400 million. The bank that engineered the package provided Moody’s with general information about the borrowers but Moody’s did not seek to consult individual files or confirm the data. “We are not loan officers, our expertise is as statistician on an aggregate basis” explained Claire Robinson from Moody’s.
Indeed, Moody’s Modus Operanti is simply to assess the likeliness of default based on average historical data and information about similar products. The structure would be inspected but the underlying assets (the real mortgage loans that made up the package) would never be looked at. Nobody was in charge of assessing the underlying risk, except the loan officers who has little incentive to do so since they knew that the mortgage would be sold and that they wouldn’t have to support the risk.
Bad behaviour supported by bad statistics
In the end, CRAs were just statisticians, and bad ones with that. Their data was outdated at best and misleading at worst. They based their models on the way house prices reacted to the 2002 downturn. But this downturn was unique in that the Fed had pushed interest rates as far as they would go and house prices kept rising.
Furthermore, they were over reliant on opaque statistical models and algorithms derived from the Gauss law. The Gauss law when applied produces the well-known bell curve whereby the number of individuals decreases as we move away from the average. But the Gauss Law (which is the foundation of many of the algorithms and formulas used in the financial world) is flawed in that it over-emphasizes the average and underestimates the probability of extreme events. As we can see on the bell curve, the number of subjects associated to extreme (meaning very far from the average figure) figures is fairly low.
All in all, CRAs underestimated the likelihood how extreme events such as a sharp decline in home prices. They assumed that times would always be good and that home prices could only rise in the foreseeable future.
The CRAs question raises a number of issues that are as much philosophical as they are economic and financial. The regulations surrounding them and the power governments gave to them stem from an insane desire to regulate the behaviour of thousands of investors and to define the indefinable.
Defining risk is impossible. Risk is multiform and in constant evolution. Giving a fixed, official definition of risk will just make investors focus on a certain kind of risk and blind them to new forms that are beyond the scope of the official definition. By forcing investors to refer to notations given by inherently imperfect organizations staffed with normal human being, regulators have highly increased the probability of the current financial disaster.
In the end, it is all about the kind of capitalism we want. Do we want a system in which free and responsible investors do their own research and take a careful look at the solidity of the assets they buy or do we want a system that sees investors stripped of their responsibility by the nanny state being pushed to blindly trust the findings or a handful of government mandated agencies? Had regulators not tried to rigidly define risk in the first place, investors would have had to do their own math, check for themselves the risk associated to certain assets and decide of the appropriate level of capital they had to carry.
CRA were governments’ way of crating a fictitious impression of security and stability. Liberalism is about separating government from business and making it as small as possible. What regulators have done is old fashion dirigism with the connivance of private actors. Strict regulations laying out what you may or may not do, which assets you may or may not hold only exacerbate economic cycles and make investors behave like sheep and follow the herd. While having all investors act the same way because regulators mandates them to (be it via direct intervention or by forcing them to act according to CRAs ratings) might be comforting for politicians and the general public whose understanding of financial market is imperfect at best, it makes crisis all the more serious.
When times are good and the AAA stamp is hot, investors all run after the same assets and trip over each other to get into the same markets. But when things go wrong and the train goes off the tracks, everybody in the market gets clobbered. These repeated attempts to use government intervention to make the system risk proof do nothing but make us more vulnerable to small changes in the market that would otherwise have been quickly absorbed. In the words of John Norberg, “Every attempt at diversification or adaptation has been wiped out by precautionary principles” and investors have come to resemble a sad herd of sheep because of government regulations. Investors should not act the same; this is not what the free market is about, this is not how we will build a stable and efficient financial system.
Government is the problem, not the solution
So what now? Many call for governments to take over the job of CRA and would like to see the creation of an official state run rating agency. But the underlying problem would remain. Companies (especially state owned ones) are prone to mistakes and nothing guarantees that a state run agency would do any better a job than private ones, especially if governments’ interests (for example not having their own grade lowered) come into play. State run companies do not have a good track record of honesty and reliability. The issue is not that agencies have done a bad job. If regulators had not forced investors to subscribe to their ratings the problem would have been much less acute. They would just have lost their credibility, some people would have lost money and life would have gone on. The problem is that giving legal force to CRAs (be them public or private) has simply made investors stupid.
The real solution is to strip CRAs of their legal status and come back to a freer model of capitalism. CRA have a future, just not as government-mandated structures. Their ratings should again become informational and investors should be free to ignore them. Then we will have a capitalism of smart human investors instead of a capitalism of sheep. As Hayek said, “Economics is about showing people how little they know about what they imagine they can control”. Governments and regulators should remember that.