Information, supervising the financial markets and the sub-prime crisis

For a fair while I’ve been interested in things like who appoints and pays for auditors of public companies and whether we’ve got it right (given that the information provided by auditors of companies for instance is a public or quasi public good when produced and firms have a conflict of interest in appointing their auditors).

The issue also arises in the context of ratings agencies – and the stinky situation in which agencies like Standard and Poors get so much revenue from the firms and products they rate.

I’d like to write a little more on this, but alas don’t have the time right now. But I can draw your attention to a very thought provoking post by Willem Buiter to which Brad Delong linked today.

It’s over the fold.

Basel II: Back to the drawing board

Two crucial inputs into Pillar 1 (Minimum Capital Requirements) of the proposed Basel II Framework for the International Convergence of Capital Measurement and Capital Standards have, if not gone belly-up, at least been severely compromised by the recent financial markets turmoil. They are the reliance on credit ratings provided by the internationally recognised rating agencies (currently Moodys, Standard & Poors and Fitch) and the crucial role assigned to internal models in everything from stress-testing to marking-to-model illiquid assets.

It is clear that, as regard rating complex structured products, the three internationally recognised rating agencies have done a terrible job. That is in part because rating complex structured products is very difficult. There is more to the ratings performance however. There appears to be a systematic bias in the ratings. If rating were merely difficult, you would expect as many over-ratings as under-ratings. What we see instead, is a persistent bias: ratings seem to systematically over-estimate the creditworthiness of the rated instrument or structure. The reason for this must be the distorted incentive structure faced by the rating agencies. They are inherently and deeply conflicted.

  • First, almost unique in any appraisal process, the appraiser in the rating process is paid by the seller rather than the buyer.
  • Second, the rating agencies provide (remunerated) technical assistance/advice on how to design structures that will attract the best possible rating to the very issuers whose structures they will subsequently rate.
  • Third, rating agencies increasingly provide other financial services and products than ratings (or ratings advice). As with auditors, there is the risk that the rating (audit) service may be subverted in the pursuit of remunerative sales of these other products.

I am not asserting that the rating process of complex financial instrument is unavoidably utterly corrupt and useless, although some of it probably is. Clearly, reputational considerations mitigate the conflict of interest faced by the rating agencies. The rating agencies have, for a long time, done a passable job of rating sovereign debt instruments and corporate entities. However, the principal-agent chain linking an individual or team working for some rating agency to the buyer of the security they rate is lengthy and opaque. The bottom line is that no-one any longer trusts the rating agencies judgement of the creditworthiness of complex structured instruments. That puts a huge hole in Pillar 1.

The recent financial turmoil has led to a demystification of quants and other high-tech builders and maintainers of mathematical-statistical models and algorithms. We have had a powerful reminder of the garbage in garbage out theorem. On many occasions marking to model has turned out to be marking-to-make belief or marking-to-myth. Wishful thinking dressed up in advanced mathematics remains wishful thinking. The incentives faced by the designers, maintainers and users of these models, and of those who calibrate their inputs have not been taken into account. Again conflict of interest is pervasive and inescapable.

With so many illiquid, non-traded instruments on their books (and in off-balance-sheet vehicles that may have to be brought on balance sheet again soon), many banks are confronted with the fact that fair value, when it cannot be measured objectively by a market price, is unlikely to be calculated fairly by techie employees of the bank whose activities are not understood by the banks risk managers or top management, and whose pay and prospects depend in a pretty obvious way on the numbers their models crank out. Again reputational considerations will mitigate the incentive to distort, but will not eliminate it. Turnover of quants, risk-managers and even top managers is so high that the restraining influence of reputational concerns is often weak at best.

What is Pillar 1 of Basel II without reliable and trusted rating agencies and without reliable and trusted methods for marking to model the illiquid assets of the banks? Not something I would use as a rule book for capital measurement and capital standards for banks. So whither now with Basel II?

Forcing the rating agencies to clean up their act is one necessary condition for Basel II to get back on track. This would require rating agencies to forsake all activities other than providing ratings. It also requires the end of the payment for the rating by the issuer of the security being rated. The only workable model would be payment out of a fund raised by a levy on the entire universe of securities-issuing and investing industries that rely on ratings.

As regards internal models and marking-to-model, I can see no way the cripling conflict of interest can ever be resolved for anything other than the simplest structured products – those for which even the CEO can understand the principles underlying the model and the numbers going in and coming out. This would mean that banks would not be allowed to hold on their balance sheets, or to be exposed to through off-balance sheet connections, complex structures whose valuation cannot be verified easily by third parties. This is tough and will be unpopular with the industry, but necessary for financial stability.

In any case, if a financial product is too complex for its valuation to be understood by the average Joe, it probably contributes negative marginal social value. Such complex products tend to be motivated by regulatory avoidance and tax avoidance considerations, and should be discouraged by regulatory design. True risk trading and risk sharing require simple, transparent instruments, designed for specific contingencies (states of nature), rather like elementary Arrow-Debreu securities. They dont require convoluted bundles of heterogeneous opaque contingent claims.

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Patrick
Patrick
14 years ago

This would mean that banks would not be allowed to hold on their balance sheets, or to be exposed to through off-balance sheet connections, complex structures whose valuation cannot be verified easily by third parties. This is tough and will be unpopular with the industry, but necessary for financial stability.

This is stupid. Basically, the very people most likely to understand such instruments, and amongst the most able to assess them, would not be allowed to hold them. Or, in its best light: ‘Aaaghh! I don’t understand it! Ban it, quick, ban it‘!!! Honestly, imagine life if we were governed by the average Joe system – we’d have to ditch our system of government and our legal system, to start with, and we’d probably be back to the stone age before we drew breath.

In any case, if a financial product is too complex for its valuation to be understood by the average Joe, it probably contributes negative marginal social value. Such complex products tend to be motivated by regulatory avoidance and tax avoidance considerations, and should be discouraged by regulatory design.

This too. What ‘average Joe’ understands the valuation of a share? What about a reinsurance contract? Undeniably they offer positive social value, to my mind at least. What about commodity futures? Do the ‘Joe averages’ understand them? That article was undoubtedly too complex to be understood by the average joe, ergo I posit that it probably contributed negative marginal social value.

The problem with ratings is not as such a systemic bias in ratings modelling, it is that products are structured to meet ratings model’s requirements. The problem is one of GIGO, which is a very different kind of problem.

The other main problem is that people don’t understand what the actual ratings mean, ie probability of default. They don’t, for example, tell you anything about the likely liquidity of the rated product – but, as we all remembered recently, liquidity or convertability can be a major factor in price. Then again, the ratings don’t tell you anything about ‘value’ either.

Probably the most legitimate point is in relation to over-structuring. I also suspect that a lot of CDOs are just mechanisms to turn investor’s cash into fees.

I hope that doesn’t sound over-the-top. You said it was a provocative article and indeeed I found it so.

Patrick
Patrick
14 years ago

Well, that’s a lot smarter than I rashly gave him credit for! I still don’t know if it sensible – Banks can’t hold only liquid assets, and in principle they are already, and even more so under Basel II, required (or is it only supposed?) to assess the liquidity of their portfolios.

I still think there was a lot of hyperbole if not outright nonsense in that.

Graham Bell
Graham Bell
14 years ago

Nicholas Gruen:
Slightly off-topic …. but then, in the absence of any oversight at all of low-doc loans in Australia, perhaps not.

The ones most vulnerable in our community – those with sufficient ambition to want to get away from paying horrendous rents but are excluded, often quite unfairly, from mainstream borrowing – are the ones in greatest need of legal protection and of sound impartial advice. Yet they are the ones who generally get neither protection nor advice – a lucky few do get some support from our overwhelmed voluntary community and charity organizations but they are the lucky few. The rest fall victim to these very very attractive schemes.

The problem would vanish overnight if the screen-jockeys in the finance industry got off their backside, left their whims and prejudices behind for a moment and went outside to see what was happening in the real market. They would soon realize, as have the purveyors of low-doc “loans”, that there is a profitable and sustainable market out there for low cost housing, even for unfashionable little old dumps. Australia’s migration experience has shown that after a few years of living in a little old dump, almost everyone yearns for a better house; that’s just a normal part of the human condition [or the nagging-wife syndrom, if you like]. The mainstream finance industry could swallow up the low-doc system in a matter of weeks but it will never happen in Australia because of their set-in-concrete mindset.

You are pondering what auditors and ratings agencies do. That’s fine enough …. but getting some sort of oversight, any oversight, on the low-doc “loan” field is far more urgent. Not from a social justice aspect – although that is important. Nor from the aspects of financial stability and reliability either – they are important too. But from a national security aspect. Quite a few of those who become victims of low-doc “loans” could well be true dropkicks and absolute dills, real born losers, but the rest are both impoverished and very ambitious …. a very dangerous combination in our troubled times. Do you imagine that some very nasty groups would neglect to seek out willing recruits from among those who have lost everything?

Sorry but your present discussion, necessary and interesting though it is, seems to me to be like rearranging the deck-chairs on the Titanic when there is a far more urgent and potentially hazardous issue to be tackled.

Patrick
Patrick
14 years ago

Er, Graham, I hate to burst your bubble, but I believe the reason that ‘low-doc’ loans, pawn broking and payday lending all exist is because that legal protection you crave is actually what does exclude and marginalise these people.

NG I believe is along the same lines as I am here – there have been numerous studies into iniquitious lending practices that have pretty much all concluded that these leeches perform a useful service and that social justice would be impaired if they were banned or further regulated.

Generally, if regulation is your answer then you need to think again.

Graham Bell
Graham Bell
14 years ago

Patrick:

“I believe the reason that low-doc loans, pawn broking and payday lending all exist is because that legal protection you crave is actually what does exclude and marginalise these people”.

So social injustice, policy failure, rapcious business practices and similar problems can be all blamed on “legal protection”, can they? Low-doc “loans”, pawn-broking and payday-lending are responses, not causes.

Patrick
Patrick
14 years ago

Low-doc loans, pawn-broking and payday-lending are responses, not causes

responses to social injustice and policy failure, not causes.