"The chief weapon of sea pirates, however, was their capacity to astonish. Nobody else could believe, until it was too late, how heartless and greedy they were."
--Kurt Vonnegut

My suggestion?

A more granular rating system (e.g. 1 - 100), and legal liability for the consequences negligent ratings.

Rule number one for investors: Don't invest in what you don"t understand.

Try getting the (constantly changing) formula for your FICA score and you'll be told "so sorry, but it would lead to gaming the system" -- yet investment bankers are more equal than that. Just as the gold standard in the health care debate is the plan offerred to Congressmen, why not require the same level of transparency when evaluating all forms of credit worthiness; if its good enough for Goldman Sachs its good enough for the guy trying to get a credit card.

Now hold on a minute. "Satisficing" is VERY common in regulatory systems, as in much of life. In traffic laws, you either broke the law or you didn't; you got popped, and the guy going 1 mph less than you didn't. In criminal court, you're either guilty or not, and the difference may turn on a twitch in one witness's eye. A product is either safe to market or it's not, a securities filing is either fraudulent or it's not, etc., etc.

Also, it's not like there is only one rating of securities; in fact, there are all sorts of levels and sub-levels -- a bewildering array of them, in fact, that have evolved over time.

AND there are other means of judging securities; for example, their yields -- a very nice, continuous, easily understood measure indeed!

Granted the ratings agencies contributed to the current situation, but IMHO that was more a case of conflict of interest than one of failure of tools and methods. And it's far from clear how keeping rating models secret would help transparency or liquidity -- or even that they could be kept secret for long, given the turnover in the industry and the immense sums of money involved.

Sorry, but this strikes me as a bit of a tempest in a teapot.

"Which is a bad thing, right?"

Actually it is a good thing for loans to people with inadequate income and collateral to go away. Such loans are what caused the problem.

I don't think the model they give to bankers is identical to their internal model (otherwise, what would the Moody's analysts do for a living?).

Agreed that the real problems are a) insufficient granularity in the rankings, and b) excessive credulity by the investors.

I really don't have too much sympathy for the investors who tried to buy something that seemed too good to be true.

As to the first part of the post, I wonder if keeping the formula hidden is a realistic option. Some people will know the formula, and they can be hired away for a price or can put out leaks. I also wonder whether or not you would get or more suspicions that ratings are done quid pro quo or lawsuits from low-rated funds claiming that they were maliciously rated.

As to the second part, demanding greater transparency would be a huge step forward. That way, the ratings would not be controlled by the ratings agencies. You can make arguments for or against regulation, but transparency is an obvious net positive.

A layman's response might be to start with raising capital requirements and see what happens. If the behavior of institutions active in financial markets appears to bear a resemblance to gamblers at a casino betting mostly with someone else's money, increasing the stake they must put it themselves would seem a good way to induce caution. Caution is no guarantee against financial misfortune, but it's a good place to start.

Is increasing capital requirements enough, though? I honestly have no idea. I suspect, though, that the problems involved with strengthening regulation may be greater than they seem. The gap between what is happening in financial markets, and what government regulators understand about what is happening in financial markets, may well be much greater than it was 30 or so years ago. I could be persuaded that this gap can be bridged, and that more regulation might make sense. It just looks to me as if this policy option could involve some formidable difficulties.

Is it the kind of thing you think would happen if the agencies were more interested in providing honest ratings than in attracting lucrative Wall Street business?

As long as the first bubble is expanding, this bubble will not have any problems. I'm sure that this was the feeling behind this rating system - this was just business as usual.

Nobody expects the Spanish Inquisition or having their bubble bursting.

Which is a bad thing, right? Because those complex instruments really do serve a purpose by reducing friction in financial markets and making more money available to more people.

Well, that's one way of looking at it. The other way to look at it is that these complex instruments allow the financial markets to pretend to reduce friction and 'make more money available' (out of thin air?) while engaging in money-making fraud.

After all, 419 scams are making money available to poor Nigerians, and reducing the friction neccessary for them to acquire it.

max
['You been had, Kevin.']

"I really don't have too much sympathy for the investors who tried to buy something that seemed too good to be true."
Thats probably includes your pension funds manager.

Brad De Longs blog has a graph titled:
http://delong.typepad.com/
The End of Securitized Mortgage Lending.

That really makes Kevin's point for him.

There's at least one systemic problem -- rating agency folks are dumber than those at the investment banks.

The reason is simple. Rating agencies pay less. Rating agency folks work with many I-bankers. I-bankers quickly hire the smart ones away.

So rating agency folks tend to be inexperienced or not smart enough to be hired by an I-bank or both.

Anyone who works on the street in structured finance will tell you that the rating agency folks tend to be among the dumbest on any deal.

What it ultimately comes down to is greed getting the better of sound judgment and due diligence. As long as everyone is making money, they don't care about about ethics, outright criminal activity, or flagrant lies going on behind the scenes.

Your average shareholder only suddenly discovers the value of ethics when the CEO is being hauled away in handcuffs and the stock is tanking. They sure didn't care as long as the stock was going up.

Greenspan's job was to take away the punch bowl when the party got started, instead he dumped some more gin into the bowl and went outside for a smoke.

The solution is to have a monetary system based on reality (start here & here) and not 18th Century delusional fantasy which is what we currently have.

Not, of course, that I have any expectations that this is likely to happen anytime soon.

“Data always beats theories. 'Look at data three times and then come to a conclusion,' versus 'coming to a conclusion and searching for some data.' The former will win every time.” - Matthew Simmons

What do we do? We insist the Federal Reserve do its job, which is to regulate capitalism so that it doesn't create situations like the one the US is currently in with the sub-prime scam. The mandate of the Fed includes the protection/regulation of lenders and borrowers alike to prevent greed from taking over the system. Up here in Canada, the regulators are extremely vigilant about financial schemes and, guess what, the sub-prime debacle didn't happen here and would not be possible within the current regulatory structure. The only impact felt was by a few Canadian banks who bought relatively small amounts of sub-prime paper as 'investments'. The US is the wild west when it comes to financial greed. History has now proven Alan (Mr. Magoo) Greenspan to be the bubble meister.

We insist the Federal Reserve do its job, which is to regulate capitalism so that it doesn't create situations like the one the US is currently in with the sub-prime scam.

For many years following the Great Depression we had a regulatory regime that was harsh and restrictive, and which kept things like the current bubbles from forming.

Eventually all the people with bad memories of the Depression retired and/or died, and a new generation started removing the regulatory framework a piece at a time. Now, with most of the pieces gone or unsupported, the regulatory framework can't stop the boom/bust of bubble cycle which is the natural state of laissez faire capitalism.

We need to make finance a much more regimented and less interesting field to work in. As the leeway and the salaries go down, the sharp operators who drive this crap will leave and go somewhere else less damaging.

I'm not sure why all of this comes as such a surprise to people. Putting money in the stock market has long since ceased to be "investing" in any meaningful sense and lapsed into little more than gambling. Hardly anyone is buying stock in a company because it is building factories or creating a new product line of tangible value over time, with jobs and all the attendant benefits to a local economy. Instead, money is simply thrown after whatever seems likely to make the biggest (and quickest) killing. That atmosphere is ripe for bubbles and fraud, and sadly explains much of what "investing" has become. We really have no one to blame but ourselves.

So what do we do? Regulate the rating agencies? Demand greater transparency? Just amp up capital requirements and leave the rest alone? Or what?

The most effective solution, IMO is to change the way loans are originated and the type of loans that can be offered. The ratings side of the mess is a big one, but origination and sale of the mortgages right at the beginning is where regulation would have the best effect. There should NEVER have been negative amortization Pick A Payment™ financing, zero down payments, "2/28" teaser rate loans, improper documentation, etc.,etc. Look at the horrendous distortion and waste in investment this has all caused-if those trillions had been invested in better LONGER-TERM JOBS for Americans instead of a bunch of monstrous boxes that nobody was ever able to afford in the first place.

So what do we do? Regulate the rating agencies? Demand greater transparency? Just amp up capital requirements and leave the rest alone? Or what?

I don't think there's one answer. While stronger regulation is undoubtedly in the cards, there are limits to transparency (at least of the data and the risk models different agencies use), and amping up capital requirements won't work unless it's based on an internationally-agreed upon framework that everyone is subject to (not just US firms), such as Basel II. And what about bond insurance, which should have helped ameliorate the effects?

It also depends on which type of agency you're talking about. There are issuer-supported and investor-supported rating agencies. They often differ significantly their risk ratings and their timeliness. No guess as to which has been more timely and accurate. However, the investor-supported firms (e.g., EJRI) are only for big guys

The issuer-supported firms (e.g., Moody's, S&P) claim, and probably correctly, that an investor-supported model won't work for them. Moreover, if they use non-public information to develop their rating, they are required to make the rating available to the public for free.

In short, there are some systemic problems that aren't going to be solved by changes in one area. However, experience suggests conflict of interest (issuer-supported) is a significant issue, and probably a good place to start. The Credit Reform Act of 2006 tried to address some of the issues, but it had no teeth and minimal effect.

Kevin,

If true, how does any issue get rated "ccc" extreme junk?

If we taxed these purveyors of riskless weath to the point of inchoherence, we'd have the dough to clean up their messes.

Kevin--how explain a rating of triple (small) 'c'? As those deals put together by the dumber guys on The Street?

Painfully progressive taxes would go a long way to solve this problem.

Kevin Drum Says

And if complex instruments become too toxic for pension funds and local governments and mainstream money managers, then the market for them essentially goes away. Which is a bad thing, right? Because those complex instruments really do serve a purpose by reducing friction in financial markets and making more money available to more people.

Kevin,

I'm not buying that one. These complex instruments have obviously not served the economy well.

BTW, how does one get the text to be italicised?

"The chief weapon of sea pirates, however, was their capacity to astonish...
--Kurt Vonnegut"

But... Nobody expects the Spanish Inquisition!

> The rating agencies just hand over their models
> to the Wall Street rocket scientists so they can
> probe for every weakness and tweak every loophole
> in order to put together a package that — just
> barely! — meets the agency's parameters for a
> high rating?

Well, duh. A while back (decades, before the Internet) I recall reading the shocked, shocked discovery that the grain silos in the Port of Seattle turned out to have a silo loaded with pea gravel, so they could bring the amount of garbage allowed in each shipment of outgoing grain up to the level just below what was forbidden.

Well, duh. The people picking fruit -- and the machines that emulate them -- know just how many bad and green items are allowed, and don't do better than the minimum. If they do a supervisor has to fix that little problem.

Well, duh. The cat and dog food from China was dosed with melamine, a nitrogen-containing plastic, so it would pass the test for total nitrogen available because total nitrogen is a lot cheaper to test for than actual protein available, so the makers figured, hey, our tast is to pass the test. And they did, and the animals died.

Well, duh. Blood transfusions. Fireproof plastics. Lead in plumbing.

The free market can't work successfully if the people making the products don't know exactly how to cheat successfully, you know.

Thus disclosure is the name of the game.

Kevin - The rating agencies don't simply "hand over" their models to the investment bankers. They sell them the model through their consulting arms.

Yup. The issuer-supported agencies only get paid on the initial issuance--they don't get paid to rerate, and anything they learn from past performance is applied to new issues, not necessarily retroactively applied.

Once rated and issued, there's little incentive to keep an eye on things--and when it happens, it tends to be due to major changes, and behind the curve, as it can take quite a while for sufficient statistical evidence to roll in.

However, as moody blue points out, they have products they're happy to sell you for doing your own ongoing risk evaluation.

Maybe? Maybe it's a ratings bubble?

I blogged about this a week ago, when an advance version of the story was put online.

Kevin, nice to see that you've started the new week with what could win your weakest post of the week award.

Oh, and instead of asking rhetorical questions at the end, why not opine a few solutions, even if tentative ones?

I find it amazing that bonds that have the same rating can have significantly different yields.

RIght now the biggest joke is the idea that the bond insurers like MBIA are AAA. They have hugh yields.

The market knows that they aren't AAA but everyone needs to 'pretend' that they are because the financial markets might fall apart if they realized that a particular prince(s) aren't wearing any clothes.

You're a RUBE, Kevin. Want to be called a taxicab, too?

As for your next to last graf, there's a HUGE difference between "reducing friction" and "greasing the skids," Kevin.

Why don't you ask Brad DeLong for more of his fucking nonenlightened "wisdom"?

Gadfly, I'm sure there's a more pithy way of putting it, involving sex, of course.

Lew, you can look thru the page source code by clicking view and then clicking page source in the browser.

The Vonnegut quote, by Bartlesby [Quote man], used the 'i' tag.

I have a solution, do away with the Ponzi scheme known as the stock market.

SocraticGadfly -- OK, you state, "It’s clear that only major federal regulation can put this horse back in the barn and keep it there."

So what specifically do you suggest? Regulate the rating agencies? Demand greater transparency? Just amp up capital requirements and leave the rest alone? Or what?

Here is a clue.

Each one of Moody's statisticians went to school and learned that a monopoly ratings system will be a disaster.

They went to Moody's, the monopoly ratings agency, for employment. If you need any other clue that Moody's is a corrupt monopoly, look no further.

Don't be so quick to single out Moody's. Every issue requires ratings from two agencies. And they both get paid. Guess who the other one is (hint: it ain't Fitch)?

<i> and </i>

[took me a minute to remember the lt [less than] and gt [greater than] that makes the visible when using the actual html tag. =P

So, what is money today? Paper that is not dollars? | and 0 on a hard drive?

Yeah, I stopped and read that part two or three times to make sure I was reading it correctly. But actually, the part that really made me stop in disbelief was that the banks only pay if they get the desired rating. It's not as if the agencies aren't doing the evaluation and the work either way. Now that really stacks the deck, doesn't it?

Pure unadulterated facisim.

The rating agencies just hand over their models to the Wall Street rocket scientists so they can probe for every weakness and tweak every loophole in order to put together a package that — just barely! — meets the agency's parameters for a high rating? Does this sound like a recipe for disaster to you?

The closest analogy I can think of is the MPAA, which gives ratings based on, well, who knows? Some movie companies certainly seem to have a hard time figuring out where the borderlines are.

But an obvious possibility comes to mind, which other commenters must know more about than I do: One is that in some decision-making domains, measures of uncertainty associated with numbers like ratings. I may say, for example, that a financial package has such and such a rating, but that it's an estimate with a lot of variance. (That is, not the likelihood of defaulting, but uncertainty in my estimate of that likelihood, perhaps due to the complexity of what I'm evaluating). Such uncertainty has to exist, right? Especially if these are prospective estimates.

Because those complex instruments really do serve a purpose by reducing friction in financial markets and making more money available to more people.
Why do you think this is a true statement? A bunch of people who like to gamble on interest rates say it's true, but I'm not seeing it. They may want to shift risks, but why shouldn't they hold the risks they took, or take the loss.

Well funded, independent regulators are taboo to industries for good reason, they protect investors and clients of the business institutions they monitor. Corrupt the regulator and there is nothing to be done but say buyer beware, which stifles trade due to a lack of transparent information.

RSA -- Depends on whether or not your model is forward-looking, or historical/statistical. The latter is the primary basis Moody's, S&P, et. al. projections.

Which is the reason they gave in many cases for waiting 2+ years to adjust projections/ratings (or "season" the issue--waiting for historical/statistical evidence), why they're behind the curve, why they've ended up a day late and a dollar short, and why anyone who depended on their historical/statistical analysis for instruments with little or no historical/statistical record was caught short.

As Mason stated:

It is, therefore,difficult – if not statistically impossible – to statistically predict mortgage pool performance at deal inception. Only after a pool is adequately seasoned (roughly two years) does the pool contain sufficient history to support statistical analysis that can b eused to predict performance in a manner the leads to stable ratings. It is not surprising, therefore, that many recent downgrades were applied to pools constructed from 2005 and 2006 vintages.

Indeed, when S&P analysts were asked in a conference call regarding the downgrades why the securities had not been downgraded earlier, they replied, because, "...it takes time for the deals to demonstrate their performance." The question, then, becomes how the deals were rated in the first place and why they were not monitored more closely for rating stability.

just a good old fashion hanging will suffice...

Because those complex instruments really do serve a purpose by reducing friction in financial markets and making more money available to more people.

BS! These "instruments" are often means to avoid regulatory restrictions, nothing more.

One thing any sensible person would do is go on strike-do not buy American securities. I invested in stocks for 40 years, but now feel American capitalism is so shot through with moral corruption that the country is not investable. My investing is in foreign stock funds now.

How about people who buy financial assets should know what they're buying rather than depending on someone else? Sure, the ratings agencies fell down, but the fundamental problem were the investors who bought stuff they couldn't understand just because it had a label - a label needless to say which didn't mean what they thought it meant.

bob h, how's that working out for you? I have a diversified portfolio, but for the first quarter, the foreign stocks underperformed the U.S. stocks. This is not an idiosyncratic result: the Wall Street Journal indicates that foreign markets have dramatically underperformed the U.S. market over the past 3 to 6 months.

KD: Because those complex instruments really do serve a purpose by reducing friction in financial markets and making more money available to more people.

Rolling on the floor laughing.

More like making obscene amounts of money for a handful of people and scamming everyone else. How can you still not get that it was nothing but a giant hyper-leveraged circle jerk?

'This country belongs to the people. Its resources, its business, its laws, its institutions, should be utilized, maintained, or altered in whatever manner will best promote the general interest.' - Theodore Roosevelt

It doesn't really matter if the agencies publish their formulas, the banks will just reverse engineer them. There are enough data points that those formulas would be impossible to keep secret.

Kevin,

I have to agree with the other posters that more complex doesn't equal more efficient in financial markets any more than more features in software means more productivity.

Efficient markets work best on commodity products. The wizards of Wall St. know that. Financial "innovations" are an attempt to create less efficients markets - not more.

For the people devising complex financial instruments, the primary driver is to build a temporary market advantage and make hundreds of millions of dollars.

The long term effect after the things get sorted out will be greater efficiency, but there is a cost in the meantime.

Hard as I try I still can't understand how all the Wall Street creative scams continue to bilk more money from ordinary investors with impunity.

Most of the financial wizards and corporate mavens long ago figured out that the federal government has even less understanding of these crafty hucksters and Ponzi Scheme boys whose main purpose is to make their hedge fund and derivative trading scams untouchable by federal IRS auditors and regulators.

Even more laughable is the so-called watchdog agency that ostensibly was created to prevent insider trading and other fraudulent transactions that take place on a daily basis, the Securities Exchange Commission (SEC). The SEC is now headed by another Bush crony and former Republican congressman from California, Christopher Cox.

Cox's so-called "oversight" has promoted the wishes of the Fat Cats and Wall Street swindlers and turned the SEC into a tax-avoidance haven.

At one time the Bush administration actually tried to make a pretense of oversight when Harvey Pitt was appointed to SEC to act as a cover-man for the Wall Street crowd. Prior to his appointment by Bush he represented corporate CEO clients against SEC charges of fraudulent accounting practices. But, it soon became apparent that the only reason he was installed in this position was to confuse and obstruct the processes of investigation and to twhart justice.

With Cox now ensconced as Pitt's replacement, the Bush mob no longer conceals the fact that Cox's main purpose at the SEC is to look the other way while the perpetrators of corporate fraud remain immune from prosecution.

What do you expect when the rating agencies get paid by the folks who are selling the debt securities?

If they don't get treated with kid gloves, they'll just move on from Moody's and go to S&P or Fitch. And while the rating agencies would like to pretend they have a wall between the bean counters and the analysts, the analysts who are making rating decisions know damn well the revenue hit they can cause by going by the book.

Thanks for the explanation and correction, has407.

I lived through the age of "Improved quality via Japanese Management Techniques (tm)" with QPRIDE and "Do it right the first time" and the Malcolm Baldrige award and ISO 9000 and all the other catchy names I forget. From that I have learned one thing.

You better be very, very careful what you measure for, because people will ALWAYS find a way to give it to you. If they need to lie, if they need to use a loophole, if they need to change definitions, by golly you will ALWAYS get what you measure for.

Measurement secrecy doesn't work because it won't stay secret. You must have no loopholes, no ambiguities, no cases where a tiny change yields big results, and you must verify and have someone verify the verifiers so any fraud requires a conspiracy.

That is assuming you really do want to regulate something. In this day of 'recommendations' and 'voluntary compliance' it is pretty obvious the government doesn't really want to regulate business or finance at all.

Until it becomes an adversarial process it won't work. You know, checks and balances. Americans know how to do this. Get going.

Richard,

Hard as I try I still can't understand how all the Wall Street creative scams continue to bilk more money from ordinary investors with impunity.

I think the remainder of your comment did a great job of answering your own question.

In a word - fraud. Fraud by a large group of people up to and including our President.

There are politicians, industry big-wigs (especially in the financial industry), and academia involved.

Look at when the tri-lateral commission really got started (73) and what has happened since.

Libertarians think a free market would have no fraud. Authoritarian followers think "Republicans are good for business." Republicans think "lowering taxes increases tax revenue."

Children are taught unions are bad and working alone is always best - "An army of one, a few good men, personal responsibility."

Our legal system proclaims that corporations have the same rights as individuals.

If someone complains about stagnant wages they are always told the exceptional cases of major athletes or entertainment superstars. (CEOs are now off the public list). We are told that because Michael Jordon negotiates as an individual so should we. Forget the fact that Michael Jordon has huge power due to his uniqueness and the average worker has none of that power. The average worker is just a faceless "human resource" like electricity or copy paper or any of the other fungible consumables a business tries to reduce.

Kevin,

I think we should do with the filthy capitalists what the Soviets did - shoot them as class enemies. That will teach them not to structure deals to satisfy the ratings agencies!

DBL: I think we should do with the filthy capitalists what the Soviets did - shoot them as class enemies.

When are you going to learn a little history? They weren't shot - they were sent to gulags.

Of course this was improved upon by Mao and Pol Pot, who perfected re-education. Uh, you don't wear glasses, do you?

I wouldn't be too upset if some large televised "show trials" were held for real perpetrators of real "economic crimes". One big problem with the system-there isn't enough jail time to deter these people-fraud is treated far too casually.

I've never understood your argument that we need these complex investments to create liquidity or "reduce friction" as you say today. The very size of the US economy would mean that there would be many, many of the simple investments around. I would think that the sheer volume of investors and lenders available should provide PLENTY of liquidity all by itself. And if the smarty pants investors need something tailored to their own needs they could combine various simple investments to create suitable for their own purposes. At least that's how it seems to me. After all, even the most complex investment can be broken down into a number of very simple components. The difference is that they don't have transparency, whereas you would have lots of transparency if you made up your own portfolio of simple investments.

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