Everybody’s looking for somebody to blame for the drama in the credit markets. Here’s a promising villain: Chester Floyd Carlson, a fabulously wealthy Wall Street fat cat whose business helped undermine the independence of the major credit-rating agencies and enabled the massive violation of intellectual-property laws. Never heard of him? He’s been dead since 1968, but his invention — photocopying — made him a rich man, built Xerox, and incidentally changed the way bond-rating agencies do business.
Before the 1970s, ratings agencies charged investors for access to information about the creditworthiness of debt issuers. If an investment house was thinking about picking up $10 million worth of XYZ Corp. paper, it would pay a fee to Moody’s or Standard & Poor’s in exchange for detailed information about the finances of XYZ Corp. The incentive structure was good: Ratings agencies depended on their reputation for providing accurate, reliable, unbiased information, and their clients, who were putting their own money at risk, had an incentive to demand appropriate caution.
But by the 1970s, American businesses were in the throes of an information revolution enabled by the genius of Carlson, who had been a patent attorney before a combination of public-library research and kitchen-sink experimentation earned him a place alongside Thomas Edison in the pantheon of great American inventors. Suddenly, documents cost a lot less to reproduce and distribute, people were ignoring copyright left and right, and credit-ratings agencies found themselves in much the same position as music labels at the advent of file-sharing: worried that their content, the lifeblood of their businesses, would be made available to consumers who were not paying them for it.
The ratings agencies responded by changing their business model: Instead of charging investors for access to credit information, they began charging debt issuers to rate their bonds. Borrowers, not lenders, were footing the bill. What this meant, in practice, was that bond-issuers were paying ratings agencies to certify their bonds as “investment grade,” a rating that allows banks, insurance companies, and other regulated financial institutions to invest in them. This created a radically different incentive structure: If an agency alienated a big customer with a low credit rating, it stood to lose millions of dollars. The ratings agencies deny that this presents a problem, but the evidence argues otherwise. Consider this now-infamous instant-message exchange between two Standard & Poor’s employees:
“This deal is ridiculous.”
“I know it definitely does not capture half the risk.”
“We should not be rating it.”
“We rate every deal.”
“It could be structured by cows and we would rate it.”
The cows have come home to Wall Street, and the manure is piled high. That remark about cows found its way into congressional testimony. Rep. Henry Waxman, no friend of the free market, now has the raters in his crosshairs.
While there has been much derision of deregulation at the hands of Ronald Reagan and Phil Gramm, Wall Street remains a highly regulated place. From banks to brokerages, from blue-chip stocks to corporate bonds, moving money around is an activity in which Uncle Sam takes an active interest. There’s a whole rogues’ gallery of regulators out there — the SEC, the Fed, and the Commerce Department, as well as international players, the Basel Committee on Banking Supervision most prominent among them. Banks and similar regulated financial institutions are required by law to put their money into “investment grade” assets. And the question of whether a security is “investment grade” depends upon the evaluation of a very small number of elite firms given the federal government’s imprimatur. These credit-raters are called “nationally recognized statistical rating organizations” — NRSROs — an obscure designation for firms that are anything but: Moody’s, Standard & Poor’s, and Fitch are the big dogs in the industry.
Lawrence White, a professor at NYU’s Stern School of Business, offers an economist’s deadpan assessment of the situation: “There was insufficient attention to risk.” Risk isn’t always easy to get your head around. The bank and insurance regulators in the 1930s and 1940s tried to make things easier for themselves by insisting that the institutions they oversaw keep their money in “safe” assets, and the SEC wanted the same for the broker-dealers under its jurisdiction. So in 1975 it created the NRSRO designation and immediately conferred it on Moody’s, S&P, and Fitch. A few new players have come and gone over the years, but these three have basically owned the market. The SEC didn’t mean to create a cartel — like much that goes wrong in public life, it was an unintended consequence of well-intended regulation. “They’ve got a lock,” says White, “a protected oligopoly. They think, ‘No matter what we do, we’re going to get paid.’ And it’s even more so in the case of structured finance.”
“Structured finance” means things like collateralized debt obligations, mortgage-backed securities, credit derivatives — all the head-clutchingly complex stuff that has bled out of the Financial Times into USA Today. The role of the credit-ratings agencies in structured finance is particularly important, White explains, because those assets are more difficult to value than plain-vanilla corporate bonds.
“General Motors has public information, there’s the annual report, there’s newspaper stories, there’s lots of stuff you can gather to assess the company, and you can look it up,” says White. “Structured finance is all about the underlying collateral, so you have much more limited information. It’s a dense and complicated story, much harder to absorb than the balance sheet and operating statement of General Motors.”
Nobody thinks the ratings agencies did a very good job in the run-up to meltdown. What isn’t clear is whether they are capable of doing a better job.
“Most people who follow this in an objective way think that these ratings are useless. They’re not a good indicator of corporate performance, and they’re not very timely,” says Jonathan Macey, a professor of securities law at Yale. “What we’re talking about here is the modern equivalent of a witch doctor. They purport to cure people or, in the case of agencies, to figure out which securities are good. And they really can’t do that. The ratings agencies are a regulatory cartel. Most people say they have to do a better job, but there is no way they’re going to do a better job, for the same reason the witch doctor isn’t going to do an appendectomy: They don’t have the capability, incentives, or training. If these guys could really pick out assets, they’d be working at hedge funds.”
The best evidence against the ratings cartel is its own performance.
“Credit-rating agencies aren’t going to be able to outperform the capital market when it comes to seeing the future,” Macey says. “They’re just slapping on a rating, and the market will act much more efficiently by slapping on a price. Share price is an advance leading indicator. Credit ratings are a lagging indicator.” As an example, Macey cites the case of Enron. Enron’s stock dropped from $90 to $8.41 a share as its troubles became known, but its credit rating was never downgraded — not until four days before the company declared bankruptcy, when Moody’s and S&P got around to taking another look.
So what to do? Macey’s answer is to abandon the ratings system and to make the financial institutions themselves directly responsible for evaluating their assets. “In a world without ratings, I’ve got to do my own analysis — look at public information, make my own calls,” Macey argues. “Others may outperform me, and then I look like an idiot. And that’s the huge value of ratings agencies for a bureaucrat at an insurance company or mutual fund: They can say, ‘Don’t blame me, it was all rated AAA,’ even if it’s CDO crap.”
Because millions or billions of dollars can be made or lost on a credit rating, there is a tremendous temptation to focus on the rating itself rather than on the underlying reality that the rating is intended to represent. This is a classic blunder of mistaking the map for the territory, the model for the thing the model is intended to represent. White and Macey offer variations on the same solution: requiring financial institutions to justify the assets themselves, rather than merely reference the credit rating given to the assets.
It’s not clear that regulators are capable of keeping up with the markets, or that the ratings racket can be reformed. When photocopying spurred a radical rethinking of the credit-raters’ business model, the regulators were not able to foresee the consequences. And for all their faults, the ratings agencies didn’t turn out to be as dumb as the investors themselves, who toward the end were barely distinguishing between risky junk bonds and Treasury bonds.
“The interest-rate spreads between junk bonds and U.S. Treasury issuance of similar durations had narrowed to 250 basis points — two and a half percentage points — as opposed to the 500 or 600, five to six percentage points, that had previously been the norm,” White says. “Even these raters were saying this was below investment grade. Why were investors buying? Why were banks lending to private-equity firms and not putting sufficient covenants in? There’s something about what was going on in this era. It isn’t all greed, it isn’t all drinking the Kool-Aid. There’s something more. I wish I understood it.”
Professor White has spent a lifetime studying these issues and still doesn’t understand it. Henry Waxman is a left-wing lawyer representing Beverly Hills and thinks he’s got it all figured out. Guess who’s going to write the new regulations?