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Old 01-04-2009, 12:43 PM
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Mary Pat Campbell
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Default Rating agencies, regulation, and capital

Recently the WSJ ran an op-ed and an editorial relating to mispricing of risk, and noting the role to credit rating agencies.

The op-ed: Let's write rating agencies out of our law

The editorial: Credit Default Swamp

As is my Sunday afternoon tradition, I sent off a letter to the editor of the WSJ:
Quote:
I agree with Mr. Rosenkranz and the editors that regulations rely too much on the Big Three rating agencies to measure the riskiness of assets. Part of the problem is in how the agencies are compensated; once, they were paid by the buyers of debt, now they are paid by issuers. The interests there are obviously divergent. To be sure, if a rating agency was too wrong too often, it would lose its reputation and perhaps its government imprimatur -- but the government moves even slower than do credit ratings.

Another obvious problem is the barrier to entry as an approved rating agency. As noted in the "Credit Default Swamp" editorial, the government does not have much incentive to recognize competitors to the current Big Three credit rating agencies. A review of what it takes to be given approval, and to lose it, as a credit rating agency may be one of the quicker regulatory fixes that could happen in the current political climate.

In light of these issues, I don't think Mr. Rosenkranz's proposal to measure riskiness by spreads over Treasuries really fixes the problem. While the market has virtues not held by regulators and credit rating agencies, with regards to structured financial products, there is not much proof that the market prices the risk well. The models used to price CDOs, CDSs, MBSs, CMOs, and other three-lettered horrors are complicated, and highly divergent parameter sets produce different spreads. We have seen recently that the models for mortgage-backed securities made certain assumptions about the quality of collateral, and the recovery given default, which have turned out to be greatly different from reality.

Moving from credit rating agencies as a basis for measuring risk, to market prices, may be a little improvement, but it doesn't fix an underlying problem: individual entity responsibility for its own risk management. Just as insurance companies and banks can point to the rating agencies to cry, "But they rated those assets AAA!", in a spread-based world the companies can cry, "But the spreads were low!"

Pushing off responsibility to third parties, whether rating agencies or the market, will not give the impetus to companies to do a hard analysis of their own positions, nor does it give incentive to fight against mispricing of risk.
I do wonder about the role of the credit rating agencies, especially given there's basically only three players in the biz for regulatory purposes in the U.S.

How has the experience been in Canada? Europe? Asia? I assume the U.S. credit rating agencies do work in other countries, too, but I was wondering the role they play in international regulatory regimes. What might be a fix here?
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Old 01-04-2009, 05:37 PM
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Hmmm, I swear I didn't see this op-ed before I wrote the WSJ:
The end of the financial world as we know it

Quote:
OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The credit-rating agencies, for instance.

Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.

Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”

The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.
And some nastiness for the SEC (deserved, I think):
Quote:
But this should come as no surprise, for the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.

Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)
Dang. Read the whole thing. I wouldn't be surprised if someone else posted this in the Finance/Investing forum. I'm going to have to read part 2 (a proposed fix?) later.
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Old 01-05-2009, 11:42 AM
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The credit rating agencies are an unattural creation. The incentive structure was actually way better before the government got involved in the 70s.
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Old 01-05-2009, 01:25 PM
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Actually, I read an article pointing out that the current incentive structure evolved as a result of Xerox ... specifically that the rating agencies could no longer protect their investor-purchased content from being circulated to non-purchasers.

Edited to add: It was Kevin Williamson in the 12/15 issue of National Review.

Last edited by Will Durant; 01-07-2009 at 09:10 PM..
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Old 01-07-2009, 02:10 PM
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Stop the Reform-Industrial Complex!

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Am I the only guy in America who thinks that the Madoff scandal should discredit the regulatory state, rather than lead to an expansion of it?

Levitt was the chief cheerleader of what Larry Kudlow calls the "goo-goo" good government crowd--Financial Division. Did that stop Madoff? Heck no! Madoff was a big player in that crowd. Close to Levitt and other financial scolds, Madoff threw loads of money at Democrats who sat on regulatory oversight committees. Levitt even said that Madoff's niece married an SEC official.

Economist Joseph Schumpeter--the "creative destruction" guy--formulated another highly insightful economic principle called "the capture theory."

Schumpeter said that regulatory bodies that are created to control a specific industry will eventually be captured by the industry they're supposed to be regulating. The revolving doors, the overlapping social spheres, the pure intensity of incentive that comes when a group of individuals get to control the business dealings of another group of individuals--all of these add up to a situation in which greater regulation makes the system less honest.
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Old 09-24-2009, 04:57 PM
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So there was the NAIC meeting recently and let's see what happened with rating agencies:
http://www.lifeandhealthinsurancenew...an-Raters.aspx

Quote:
NATIONAL HARBOR, MD. – The National Association of Insurance Commissioners should reevaluate Securities Valuation Office reliance on rating agencies, witnesses said here today at an NAIC hearing.

The NAIC, Kansas City, Mo., should take a hard look at the rating agencies because the agencies’ poor performance helped cause the recent financial meltdown, according to New York Deputy Insurance Superintendent Michael Moriarty and Birny Birnbaum, executive director of the Center for Economic Justice, Austin, Texas.

Moriarty, Birnbaum and others were testifying at a day-long, 3-part hearing at the conclusion of the NAIC’s fall meeting.

The NAIC’s Rating Agency Working Group organized the meeting, which was chaired by Illinois Insurance Director Michael McRaith and co-chaired by New York Superintendent James Wrynn, to look at how insurance regulators came to rely on the rating agencies, what went wrong, and what to do in the future.

The SVO is an arm of the NAIC that helps insurance regulators analyze and monitor bonds, mortgage-backed securities and other investment instruments.

Earlier in this decade, the SVO responded to limits on its resources by trying to make more use of the ratings and valuations provided by third parties, such as rating agencies, Moriarty testified.

The SVO exempted insurer-owned securities rated by nationally recognized rating organizations from filing requirements, Moriarty said.

“The rationale at that time was fairly straightforward,” Moriarty said, noting that the rating agencies had a track record of reliability.

Today, however, reliance on the rating agencies should be reviewed in light of the events of the last few years, Moriarty said.
More of the story at the link.
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Old 10-01-2009, 04:31 AM
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A congressional hearing:
http://www.lifeandhealthinsurancenew...nder-Fire.aspx

Quote:
WASHINGTON BUREAU -- A House Financial Services subcommittee chairman today charged that the rating agencies betrayed “their special status under our laws” through a “ask me no questions, I’ll tell you no lies” approach to grading mortgage-backed securities.

Rep. Paul Kanjorski, D-Pa., head of the Capital Markets Subcommittee, made those comments while urging passage of a draft bill that would preserve credit rating agency independence but require the agencies to comply with standards they create and police themselves.

The Accountability and Transparency in Rating Agencies Act bill draft would give the U.S. Securities and Exchange Commission power to dictate how credit rating agencies determine ratings.

At the hearing, rating agency representatives acknowledged that their firms’ ratings performed poorly, and they said they would support many of the reforms proposed in the ATRAA draft.

But the rating agencies said they would oppose some provisions, including one that would making the rating agencies responsible for each others’ ratings through collective liability.
There's more at the link. But I don't particularly like the sound of either of the bolded parts [obviously the agencies are not happy with the second]. I can think of some things that can go wrong in this arrangement, and could even make the situation worse than it is now.
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Old 11-11-2009, 06:33 AM
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http://www.lifeandhealthinsurancenew...Evaluator.aspx

Quote:
The National Association of Insurance Commissioners could choose a residential mortgage-backed securities modeling firm by the end of the week, a regulator says.

The NAIC plenary – the body that includes all voting members of the NAIC, Kansas City, Mo. – recently approved a measure that calls for the NAIC to develop a new model for rating the residential mortgage-backed securities held by insurers.

The NAIC will be trying to reduce its reliance on ratings from the “nationally recognized statistical rating organizations” for the purpose of determining insurer risk-based capital levels.

The NAIC is planning to set up 6 soundness designations for RMBS and establish ranges of prices for each designation, and it plans to contract with an independent firm to assist with the modeling efforts.

Matti Peltonen, a bureau chief with the New York State Insurance Department, says he expects the outside firm to be chosen by the end of the week. He says the NAIC received “about two or three dozen responses” to its request for proposals, but that the NAIC will likely not make the names of the bidders public.

The American Council of Life Insurers, Washington, called for the change in September, arguing that the current NRSRO RMBS ratings fail to distinguish between securities with a total loss and those projected to suffer minor losses.

The result, ACLI said, has been skyrocketing life insurance company capital reserve requirements.
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Old 11-19-2009, 05:31 AM
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NAIC hires PIMCO to help with RMBS models
http://www.actuarialoutpost.com/actu...71#post4039571
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Old 11-19-2009, 08:15 AM
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The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!)
I thought GE was downgraded to AA.
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