My Problem with Cuomo Going After Ratings Agencies

Cuomo is suing brokers for selling AAA paper.

Attorney General Andrew Cuomo warned that his office plans to sue the largest online brokerage firm for civil fraud over its marketing and sales of auction-rate securities to clients.

Cuomo is also going after the ratings agencies, along with many others, for basically rating securities as AAA when they (many such securities, primarily MBS related to housing) subsequently defaulted. An AAA rating has a 0.03%ish annualized probability of default. My problem is that this is a mistake, not criminal. While Moody's (MCO) may have been overly incented to rate these securities highly, such an incentive has existed since the beginnings of the industry, and many other failed rating agencies neglected this at their peril (remember Duff & Phelps?). So, it's a standard incentive problem that I don't think is helped by piling on after the fact.

By itself it would not be so bad, it's just that going after brokers for selling AAA securities because they turned out riskier than expected means that now the rating agencies, and brokers, have to 'underwrite' (ie, evaluate and due thorough analysis) the same securities. It is a fact that the senior piece of some capital investment will have a low probability of default, due to the value of the underlying business. For example, if you lend someone $100k to buy a house, and the house has an independent appraisal of $300k, the probability you will lose any money on that $100k is very small; for a large portfolio, basically absent. To now say that everything must be evaluated by everyone just creates waste, because the costs are too great, the benefits too small. Remember, a growing economy comes from doing more with less, and a large part of this is in information processing. We take for granted real GDP growth, but improved financial efficiency—innovation!—is part of that. The only way to guarantee no more blow ups is to guarantee no more growth, a poor bargain (Gillian Tett's book Fool's Gold seems to think innovation is something to be discouraged).

There should be a vibrant sector of 'informationally insensitive' assets that have minuscule default rates. Such assets will be hypothecated by banks when deposited as collateral, making them effectively part of the monetary base. It's unavoidable, in the same way factional reserve banking is unavoidable.

I hope they remember that the Fed and all the regulators considered mortgages low risk because of their historical track record, which had minor losses in aggregate. No asset class has back-to-back surprises, so doubling down on mortgages is rather ahistorical from that perspective. Remember Commercial Real Estate? After its vicious 1990 cycle, default were historically low for the next 15 years (lots of concern now, to be sure, however). Better to focus on other assets that have historically been safest. Why not raise the risk levels for municipal bonds, state bonds, even US government bonds? Clearly these have a potential for massive failure in spite of their golden track record. After all, many banks defaulted after the panic of 1838, surprising the Europeans who thought this unimaginable after they seemed so strong during the earlier panic of 1819. But that would cut into the incentives of the regulators, not rich bankers (all 'bankers' are now caricatured as Goldman Sachs (GS) employees making $700k/year).

Comments

[Gregman2:]

The ratings agencies should be compelled to insured their work, just like a professional is required to carry Errors & Omissions. It's basically malpractice. If it's not criminal, then no shields should be available to the raters against civil liability.

Jul 21 11:31 AM

[ironhacker:]

If Cuomo and the other plaintiffs can prove negligence or conflict of interest, more power to them. The outcome of that process will answer some important questions: Are ratings reliable or merely a sales tool for brokers? Are they based on objective criteria or are they to be treated like overpriced blog postings?

When liar loans are packaged up as AAA investments, there are more liars involved than just the home buyers. When the contents of the investment are opaque and the credit rating becomes an important part of the investor's decision to buy, we can't have the ratings agencies in a position to benefit from high ratings that do not track with the inherent risk of the underlying investment.

Could the investors have been smarter? Hell yes. Will they rely on credit ratings in the future? I doubt it.

The ratings agencies had plenty of experience with low-rated corporate bonds, along with long-term data from mutual funds who distributed the risk of junk bonds through diversification. The difference is that a corporation will repay its bonds or the shareholders will lose their investment. A homeowner with negative equity has already lost his investment. He just mails the keys to the bank and says, "Adios".

Were the agencies so naieve to think that housing prices could never put all of these mortgages underwater simultaneously? Were they oblivious to the fact that the people writing the loans were dumping them immediately and had no vested interest in the repayment ability of the borrower? I think not.

Are the agencies incompetent, corrupt, or negligent? I'm not sure which is worse.

Jul 21 11:40 AM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:46 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:46 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:46 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:46 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:46 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:47 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:47 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:47 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:47 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:47 PM

[David Harper:]

Weak argument. The issue is whether the work product and methodology justified the fees, or if not, constituted a professional negligence. This can't be decided at the superficial level of your argument: clearly, at some hypothetical extreme, taking fees for inappropriate ratings would be actionable. The problem is that, in regard to structured products, the rating agencies *clearly* applied dubious model practices to insubstantial datasets - I don't know the legal implications, but it's worse than you make it sound. David Harper, bionicturtle.com

Jul 21 07:48 PM