Rethinking Our Inheritance

Recently the Financial Economists Roundtable (FER) posted a summary of their thinking in July 2008 on Reforming the Role of Statistical Rating Organizations [SROs] in the Securitization Process.[1] The FER is a group of senior financial economists who advance the study of finance and frame current policy debates.[2] I read their statement in the Dec. 2 issue of RGE Monitor. Like the SEC reform proposal released about the same time, the FER statement inspired no comments of passion or controversy. That is a shame, because unlike the SEC proposal, the FER statement comes close to the heart of the matter and deserves a thoughtful response, or at the very least some controversy. So, from the practitioner’s view, let me play devil’s advocate. FER’s key conclusions are that they—

1.     …support strategies designed to improve SRO incentives by increasing the transparency of their modeling practices and holding their managements accountable for negligent ratings errors.

2.     …challenge the wisdom of incorporating SRO ratings in securities and banking regulations issued by governmental entities.

3.     …recommend SROs publish an express margin for error in their ratings for every tranche of securitized instruments, to acknowledge differences in the degree of leverage that is imbedded in different issues of securitized debt.

My reading of these points is as follows—

(1)    implies that merely looking at SRO models and approaches would tell us what went wrong. That’s unlikely to be true. In the past (more than now) rating agencies historically disclosed a lot about their models, and there were flaws, but self-correction did not arise from the disclosure.

Rather, the market believed in their magic all the more fervently because they saw how the power of the SRO could overrule logic.

R&R focuses the problem differently. The lack of opportunity to study structured ratings in a formal setting contributes to the problem more subtly and profoundly than any other single factor. What is primarily needed is not more transparency but basic structured finance literacy. To be blunt, none of the 27 FER signatories are affiliated with universities where structured finance/ securitization is taught, or taught in a way that remotely corresponds to market practice. Nor is there an attempt to integrate such content into courses dealing with (i) money and banking, (ii) traditional corporate finance; (iii) portfolio analysis; or (iv) options. My remark in regards to (iv) may sound excessively harsh, since many of the affiliated universities offer credit derivatives in their curriculum as an extension of option theory. Nevertheless, there is no opportunity for formal study and critique of the underlying cash analytic framework that gives rise to ratings on structured tranches in the first place. The reason, quite simply, is the lack of academic expertise in this area. My comments, which relate to the finance curriculum in business schools, also apply to accounting.

How can we talk about elevating the standards of analysis and raising the accountability of SROs when we do not enable our MBAs to understand and follow the paradigm shifts taking place right under our noses?

(In the interest of full disclosure, fewer than ten people in the world teach real-world securitization. Sylvain Raynes and I are at least one-fifth of that population. Does my comment signify preaching for my own parish? Or does it make me somewhat uniquely qualified to raise these points?)

(2)    is a good idea. Like most market professionals, R&R principals are skeptical about government-mandated solutions for the market—most of all when they are government-mandated commercial solutions. For point (2), however, separating SROs from a quasi-regulatory role implies a capacity for self-regulation. Taking self-regulation to the limit, recommendations (1) and (3) would no longer be relevant, because the SROs would no longer matter much. The underpinnings of self-regulation lead us back to the primacy of education and training raised above (1).

But, more needs to be said about reversing the role of an institution (the SRO) that has been around 2008-1936 = 72 years. That was two decades prior to the rise of modern accounting, in the 1950s. Securitization accounting is another instance of a failed system. The frank discussion of obstacles to creating a reporting language for structured finance/securitization activities without undermining the tenets of the accounting paradigm in FASB 140, Appendix B makes for enlightening reading.[3]

Taking the idea of disclosure-based regulation to the limit, is America prepared to become the information society we would need to become in order to free ourselves from relying on designated authorities who tell us what to think? Are we prepared to shoulder responsibility for the decisions we make for ourselves, psychologically? financially? Yet, if finance is not prepared to become bold or knowledgeable enough to govern itself, why should it deserve a free market?

(3)     is where the proverbial rubber meets the road in financial theory. Credit volatility is a property of the underlying cash flows that form the credit structure of structured securities. With the passage of time, this volatility changes in a pattern that is time- and structure-dependent. Quantifying how the credit exposure improves or deteriorates is the essence of the valuation problem.

In one sense, calling credit volatility an error term shows an essential misconception about the value proposition of structured securities. But in another sense, the FER are due an enormous amount of credit for having hit the nail on the head, albeit from the canon of corporate securities valuation and stochastic calculus. Because credit volatility is real and not a result of modeling error, imposing the assumption of constant returns (static ratings) on structured securities introduces pricing errors precisely by imposing an exogenous (and incorrect) assumption about the distribution of structured risk.

Once again, in the interest of full disclosure, the commercial premise of R&R Consulting is the need for dynamic risk analysis in structured finance/securitization. We were pioneers in describing the non-stationary nature of structured risk and modeling it for the cash market.[4] Does that mean we’re “selling snake oil”? Or does it make us unusually well qualified to identify the central valuation arguments and debate them?

Other comments about the role and function of rating agencies in structured finance that can be found in the paper are important and worthy of counter-comment. I leave those for a follow-on blog.

[3] Yet, despite its shortcomings, GAAP is much closer to practical reality than IFRS. As we contemplate abandoning GAAP in favor of the European system, should we not reflect on the adverse consequences that shift would have on reviving the securitization market?
[4] Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford University Press, 2003, pp. 101-103.

Originally published at The Spectrum and reproduced here with the author’s permission.

8 Responses to "Rethinking Our Inheritance"

  1. Guest   December 16, 2008 at 3:00 pm

    Dear Ms. Rutledge, It is unclear to me if you are being critical of FER or you agree with them? If you disagree with them (this is what you are implying) can you be more specific on as to why you disagree with them?

    • Ann Rutledge   December 16, 2008 at 7:42 pm

      Thank you for your question. That is a fair comment.I agree generally that the SROs should be transparent, but I disagree that a lack of transparency per se is a cause of the crisis; I believe that a much more substantial cause is the failure of the market to know how to govern itself because of a lack of technical knowledge about structured finance and structured ratings. And, as I’ve said, I think the universities bear a much larger share of the blame than is generally recognized.I agree with the FER that SROs should not have a special status in the capital markets. However, it is also fairly clear to me that the power of the SROs is only in part a result of securities laws; their special status as the “honest broker” in the capital markets gave them a different kind of power–one that is not easily recovered when trust is gone.I do not agree that it is possible to publish statistics on error terms on structured ratings, at least in the usual sense, because structured credit quality is non-stationary. (I will say more about this in the next question.) But, if the FER were to propose publishing information on the sensitivity of ratings to certain changes in the input assumptions (a kind of DV01 on ratings w.r.t. defaults, tranche sizes, recovery rates, etc) I would strongly agree with that suggestion. It would be extremely valuable. I appreciate your question, and if I have not been specific enough, please feel free to probe further here, or email me.

  2. Anonymous   December 16, 2008 at 3:11 pm

    Dear Ms. Rutledge, the FER idea of “publishing an express margin for error in their ratings for every tranche of securitized instruments” might not be as perfect as you might wish. As a rule of thumb, however, it could be useful, don’t you think?

    • Ann Rutledge   December 16, 2008 at 9:35 pm

      Yes, and no.Jerry Fons at Moody’s in 1995 published empirical evidence of an upward ratings drift in RMBS. (That was then.) The formal basis for that drift is twofold: (a) the risk of default and prepayment over time decreases with burnout and (b) the profile of risk changes as certain classes pay off first. When this happens, the extra capital available to cover losses (credit enhancement) is spread out across fewer classes (the so-called “deleverage”) and ceteris paribus the intrinsic credit of the remaining classes improves.What all this means, is that the error term must also be a function of time.Or, alternatively (what we recommend) ratings should be refreshed with the frequency of the payment period, to reflect what the new performance data is saying about the deal that was not known at a previous time step. Updating the rating would make the error term eventually go to zero by the end of the deal. Better than that, it would enable investors to spot issuers who have a bad habit of putting deals into the market that are under-collateralized. Armed with that kind of information, investors could shun the cheaters and market discipline could once again work its wonders.

  3. Guest   December 16, 2008 at 3:14 pm

    Are you saying that the FER are not qualified to give their opinions in the FER statement because their schools don’t offer courses on securitization?

    • Ann Rutledge   December 16, 2008 at 9:49 pm

      No, I did not say that. In fact, I think I complimented the FER on their sense of materiality.However what I said was, the lack of opportunity to study structured ratings in a formal setting contributes to the problem more subtly and profoundly than any other single factor. There are certain biases in academic finance, of which Sylvain and I have both written. They need to be aired and debated from a broader perspective. Perhaps RGE Monitor is a good venue in which to do that.Larry Harris, a member of FER, came out with his book on exchange market microstructure in 2003, and it was very well received, all the more because of the lapse of 25 years or so between the full development of exchange cultures and his book. Did anyone see his book as an implicit criticism of the economists who had been writing about markets up to that point?

  4. Anonymous   December 19, 2008 at 5:51 pm

    As an ex-ratings analyst, I find amusement in trying to fix went wrong, because I see the problem as fundamentally #2.The ratings agency didn’t hire (and definitely didn’t keep) the “best and the brightest”. The salaries are less than 50% of a similar function at a bank and the potential to Get Rich Quick and live the Wall Street life doesn’t exist. As a result, we had extremely high turnover and were dependent on foreign graduates from 2nd tier schools (the vast majority of employees are sponsored).We all did our best, but because of this talent and experience difference, the agency analysts are always one or two steps behind. That is the fundamental problem.1) The models are transparent (but we had no idea if the model was wrong or right – we were just trying to figure out how a mortgage worked)2) We we never influenced by money or pricing (but if this if your first month on the job, would you ever disagree with a wealthy and successful banker who said house prices always go up)In my opinion, the banks gladly gave the agencies the ratings power because the banks knew how to control the agencies and they made the Koolaid we all drank. Looking back, I do think the bankers knew what was happening.I am amazed at the investors who put blind faith in a recent MBA graduate who was just learning how the mortgage industry worked (forget even understanding how the securitization market worked) stamping a Aaa on their bond.That power and talent difference between the agencies and the banks (and even investors) is, I believe, a substantial part of the problem that is very difficult to fix.

  5. AER   January 3, 2009 at 11:46 am

    Anonymous, I couldn’t agree more, except that the rating agencies had the power to say no. Which is considerable, if it’s used; and the de facto duopoly ensured that these institutions could say no without losing their franchise. That was the intention behind Moody’s commitment to rate all transactions, whether or not they were paid (“unsolicited ratings.”) But when the broker-dealer lobby sent the DOJ on a fishing expedition to find evidence of blackmail in 1996, they destroyed that power. The argument was: Moody’s is blackmailing the market into asking for Moody’s ratings because without a mandate, they give the debt a worse rating. In a few isolated instances there was blackmail (rating agencies have a human, competitive side too) but by and large the situation was exactly the opposite: the broker-dealers did not like the Moody’s rating and bullied them into not publishing it. AER