How to Regulate the MBS Market? Kill the Ratings Agencies

 |  Includes: DNB, MCO
by: David Goldman

What makes the administration’s proposed ban on bank proprietary trading most embarrassing is the failure to address the source of the 2008-2009 crisis: the fact that the ratings agencies concocted phony AAA ratings for securities backed by volatile subprime mortgage assets [MBS] with malice aforethought. There’s a better way to do it. I spent a good deal of time on Wall Street working with risk managers at large financial institutions, and my experience tells me that the trouble is NOT that risk is hard to measure. The hard thing is to stop corruption.

The world (as the late Fr. Richard John Neuhaus was fond of saying) is more in need of reminder than instruction, and here’s a little reminder:

Oct. 22, 2008 (Bloomberg) — Employees at Moody’s Investors Service told executives that issuing dubious creditworthy ratings to mortgage-backed securities made it appear they were incompetent or “sold our soul to the devil for revenue,” according to e-mails obtained by U.S. House investigators.

The e-mail was one of several documents made public today at a hearing of the House Oversight and Government Reform Committee in Washington, which is reviewing the role played by Moody’s, Standard & Poor’s and Fitch Ratings in the global credit freeze.

“The story of the credit rating agencies is a story of colossal failure,” Committee Chairman Henry Waxman, a California Democrat, said at the hearing. “The result is that our entire financial system is now at risk.”

Moody’s and S&P in recent months had to downgrade thousands of mortgage-backed securities, many of which were originally given top AAA ratings, asdelinquencies on the underlying loans soared well beyond the companies’ estimates and home values fell faster than they expected. The downgrades contributed to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc., and compelled the U.S. government to set up a system to buy $700 billionof distressed assets from financial companies.

The Securities and Exchange Commission in a July report found the credit-rating companies improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

An e-mail that a S&P employee wrote to a co-worker in 2006, obtained by committee investigators, said, “Let’s hope we are all wealthy and retired by the time this house of cards falters."

The fact that no-one has gone to jail for market rigging tells us how toothless and gutless the regulators are.

The ratings agencies take the position that their ratings are “opinions” with the same legal status as a newspaper editorial. Newspaper editorialists, though, aren’t paid pro rata by big advertisers for endorsing their products! The Fed let the ratings agencies take responsibility for measuring risk, and the ratings agencies declared that they are not responsible in the slightest.

The fact is that there are plenty of good risk models out there. The Moody’s analysts cited in the story above knew perfectly well what they were doing. The way to fix the problem is to rate risky securities with full transparency.

Here’s how to do it:

1) Require large financial institutions to provide their internal data for default and delinquency. The big banks have long histories of default with a great deal of detailed characteristics of defaulting companies.

2) Create a publicly available, downloadable data set with the merged data (suitable sanitized to remove company names, but including detailed borrower data such as balance sheet, sales, capital structure, and so forth.

3) Charge the Federal Reserve staff with constructing empirical default models to predict defaults based on company histories as well as market observations (my old favorite its the implied volatility of options on the stock of publicly traded companies).

4) Publish the Fed’s model along with the data set.

5) Convene an annual conference to allow academics and private analysts to critique the Fed’s model, so that the Fed staff has to answer to extensive criticism.

6) Use the Fed model to establish reserve and other risk criteria for securities.

7) Allow the private sector to take the same data and sell alternative risk models to investors who think that private analysts might do a better job than the Fed staff.

On the strength of transparent and universally accessible data, criteria can be established for capital adequacy of large banks.

By making the process open to any academic or commercial contender, the corruption inherent in the ratings process is eliminated.

This, of course, would pretty well kill the business of the ratings agencies. They should feel fortunate to get off so easily.

We don’t want to stop the banks from investing for their own account. In market panics, we want big institutions with broad shoulders to step in and buy securities that other investors are forced to sell. But we want this to happen in full light of day, in a way that the regulators and investors can understand.