The Ratings Trap
The Quote of the Day comes from an OpEd piece in the NYT, titled Rated F for Failure, by Jerome Fons and Frank Partnoy:
“Why, more than a year into the crisis, do regulators and investors continue to rely on ratings? No one has been more wrong than Moody’s and S.&P. Less than a year ago both gave high ratings to 11 of the largest distressed financial institutions. They put the insurance giant A.I.G. in the AA category. They rated Lehman Brothers an A just a month before it collapsed. Until recently, the agencies maintained AAA ratings on thousands of nearly worthless subprime-related securities.”
Interestingly, I discovered Professor Partnoy’s work while researching Bailout Nation. Here’s what I wrote regarding his views on Derivatives, circa 1997:
Immediately after the CFMA legislation was passed, a few observers raised concerns. Frank Partnoy, a former derivatives trader at Morgan Stanley (now law professor at the University of San Diego), is the author of ”F.I.A.S.C.O.: Blood in the Water on Wall Street’,’ a 1997 book warning about the danger of derivatives. In 2000, referring to CFMA, he noted:
“The new bill’s second impact, in the swaps market, is less direct but still worrisome. The act ends an argument about whether swaps qualify for regulation by making it clear that they are not regulated if a participating company or individual has $10 million in assets. That means that the swaps activities of most companies and mutual funds are not regulated. Yet few investors know what swaps are. And there’s almost no publicly available information about specific trades in this market, now bigger than many stock or bond markets. By contrast, futures trading takes place on exchanges; an investor can find closing quotes for futures in a newspaper’s financial section.”
Even Partnoy’s prescient fears failed to anticipate exactly how devastating the results of the Act would be. It was unconscionably enormous in the scale of its potential for financial Armageddon. Either directly or indirectly, unregulated derivatives trading allowed by CFMA were responsible for the biggest bankruptcies in history. It created the monster that brought down AIG, the world’s largest insurance company.
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Sources:
Rated F for Failure
JEROME S. FONS and FRANK PARTNOY
NYT, March 16, 2009
http://www.nytimes.com/2009/03/16/opinion/16partnoy.html
Stock Gambling on the Cheap
FRANK PARTNOY
New York Times, December 21, 2000
http://query.nytimes.com/gst/fullpage.html?res=9C06E6D81E39F932A15751C1A9669C8B63&sec=&spon=&pagewanted=2
March 16th, 2009 at 11:50 am
and, to go w/ that:
“In response to the shareholder lawsuit, Moody’s argued that its claims to independence and ratings integrity were just “puffery” – legalese for innocent exaggeration:
“Generalizations regarding integrity, independence and risk management amount to no more than puffery,” Moody’s said in court papers. As such, alleged “misstatements of this nature are insufficient to sustain a claim under the securities laws.”
But the judge is having none of it:
Taken together, U.S. District Judge Shirley Wohl Kram wrote in her order, the facts as alleged by the plaintiffs “belie defendants’ claims of independence and ratings integrity.” Similarly, she wrote, “the revelations that it altered ratings at the request of issuers called into question Moody’s claim that it ‘maintains independence in its relationship with issuers and other interested entities.’”
http://georgewashington2.blogspot.com/2009/03/moodys-anyone-who-believed-our-credit.html
and, tangentially, I find curious that our vaunted ‘Feminists’ are not seen by the side, in support of, women like this Judge, Shirley Wohl Kram, analysts, such as Meredith Whitney, or the many others that are, actually, doing Yeoman’s work in support of what is Right..
March 16th, 2009 at 12:11 pm
Given that regulation, is there any reason to think that any of the major banks dealing with AIG in swaps did NOT know they were dealing with unregulated products and therefore, by clear implication, products not backed by government guarantees of any sort? Did they really think there was a universe where unregulated products were going to be made good by US taxpayers?
March 16th, 2009 at 12:17 pm
@wally
you should know by now that US taxpayers will always be there to pick up the pieces from any mess Wall street creates.
March 16th, 2009 at 12:26 pm
super… of course I know it, but it doesn’t make me happy.
When I get friends in high places, will my gambling debts be made good? Or does that only happen if they are big enough debts?
March 16th, 2009 at 12:26 pm
Sometimes, the research organization underneath the bad agency is sound, but the account managers who massage the results are to blame – they essentially ignore the research and sell the rating. I don’t know for a fact that is what happened, but in MY industry (IT systems and strategy), we essentially have a paid whore industry analyst business for software and services.
That’s right, you heard it here: The unsuspecting IT buyer goes to Gartner and Forrester for unbiased research, and gets what are essentially perverted, pay-for -play white papers. They are whore houses, IT analyst houses; some are high end call girls, some are cheap blogger massage parlors.
Some combine really professional quantitative industry monitoring that is first rate, and combine this with the worst, most egregious kind of paid writing by their whores (analysts) that write what they are told to write.
It’s a devils deal, and that combination of decent quantitative surveying with virtually useless paid content muddies the waters for independent analysts, like myself, that must ‘tell it like it is”, even when the client does not want to hear a candid, potentially negative opinion.
March 16th, 2009 at 12:38 pm
MH
Thanks for the note about Moody’s. Case info lists Teamsters Local 282 Pension Trust Fund as plaintiff.
Also, a friend sent this: http://zerohedge.blogspot.com/2009/03/moodys-releases-leper-list.html
March 16th, 2009 at 12:55 pm
Let’s think of the ratings agencies as a very nice kindergarden teacher: Everyone gets a star. Most everyone gets a gold or silver star and only when they’ve run out of those do they give out the purple and green ones. No one gets told by their kindergarden teacher, “You suck, you don’t deserve any stars.” While that’s a good thing for small children, it’s certainly BS for bond ratings… Remember, AIG deserves an “A” for abysmal.
HCF
March 16th, 2009 at 1:01 pm
Nobody will argue in favor of ratings as they now exist. They are meaningless in most respects, now. But, in order for investment money to flow, you need to quantify risk, Otherwise, everything, by default, will be associated with maximum risk.
Ratings, in concept, are good. The implementation is poor because there appear to be no consequences for failure. That is the weakness.
Corruption will always exist. It will exist less if those who are susceptible to corruption are too afraid to participate because the penalties are too great. A SarbOx targeted to ratings is required. A $5 million fine or 5 years in jail is a pretty good attention getter when it comes to keeping things honest.
Unless, of course, you believe the markets are the best regulators when it comes to ratings. Like now, for instance, where no ratings are believed.
March 16th, 2009 at 1:06 pm
Does anyone think it is curious that people from Moodys and the rest of the rogue’s gallery still make the rounds to opine on CNBC?
March 16th, 2009 at 1:26 pm
re: “unregulated derivatives trading allowed by CFMA were responsible for the biggest bankruptcies in history”
A suggested working improvement:
“*required* by CFMA”
The CFMA made it *illegal* to regulate these things.
March 16th, 2009 at 1:36 pm
New Rule of Thumb:
Deregulation of the banking and/or financial industries will get you ripped-off, every time.
Every.
Time.
That’s why they want deregulation, and it’s also why they should never be deregulated.
It’s a license to steal.
March 16th, 2009 at 1:42 pm
During the Y2K period and prior, the easiest way to steal was to start a public company that had no prospect of earning a dime, but hyping it in such a way that it looked like solid gold. Then you sold worthless stock for a lot of money.
A second preferential way was to steal as an insider if you happened to work at the top executive levels. Enron explored the basics of derivatives fraud and fake commodity shortages. SarbOx closed much of this way of life off and forced the thieves to find a new way to earn a living. They discovered mortgage fraud, expanded on the ways to commit commodities fraud using derivatives, and invented swaps fraud.
Thieves are clever.
Now, where will they migrate to. The investment world is in a lull. Not much cash is flowing, but you can be sure they will find the next big things and fleece the same people again.
Commodities fraud will reappear unless the CFTC figures out how to limit direct and indirect speculation in commodities. Investors love their bubbles, and large amounts of spare cash will once again create the appearance of peak oil to the gullible, not peak oil fraud. For other schemes, crooks will probably have to move their schemes overseas where there is less regulation.
What’s there to steal now? I’m at a loss to figure it out.
March 16th, 2009 at 1:47 pm
@ Marcus:
> Deregulation of the banking and/or financial industries will get you ripped-off, every time.
Yes and no… We should separate out the topics of regulation and enforcement. Having a generally libertarian philosophy, I believe in very limited regulation, but VERY STRICT enforcement of the rules. The problem under Greenspan, et al was the appalling lack of enforcement of existing securities laws. You can’t have a law on the books and have the regulator say, “I don’t really believe in that rule anyways…” It’s like the situation in China: China has among the strictest copyright laws in the world, but zero enforcement. We know how that’s working out…
HCF
March 16th, 2009 at 1:50 pm
One good thing about the commodities market is there are no ratings agencies…. it’s a tricky market but once you figure the dodges out you can make money quite easily. It helps that oil will be going from the lower left to the upper right, of course. Basically you have to sell the rips after USO buys, “Nigerian incidents” and OPEC supply cuts and buy the dips after supply builds, green energy press conferences and warm weather forecasts.
March 16th, 2009 at 1:53 pm
leftback,
Yeah, using Nigeria as an excuse was solid gold in getting a price rise. All it tool was the rumor of significant flatulence in a small room with no windows and Vavooom went the world price of crude. The oldies never go away. This one will still work.
March 16th, 2009 at 2:06 pm
re oil prices and hype:
Let’s not forget the wonderful work on CNBC by Melissa and later by Sharon in the commodity pits, where they cheerfully regurgitated the day’s simple minded headline story as the The Big Reason Of The Day, adding credibility and urgency to the lies and the hype. Do they still do that?
March 16th, 2009 at 2:12 pm
HFC,
I hear you loud and clear. The problem is, lack of regulation is exactly why law enforcement can’t be used against AIG (not that we have law enforcement involvement where laws DO exist prohibiting chicanery – a crime in and of itself. It’s a shame this is a theoretical distinction). Like Portnoy’s comment in BR’s post, above, points out – there was no regulation under the new legislation.
As for libertarianism, I like the standard definition of ‘rights’ – namely, one’s rights end where they infringe on another’s. This goes for polluting industries, pharmeceuticals, banking, manufacturers of addictive products (for profit and/or trade), misleading marketing, and any other business activity that would toxify the environment (I use ‘enviornoment’ in the broadest sense). Hell, I’d be all for anarchy, if I thought people had the scruples to police themselves and the morals and ethics to control their lust to get more of anything they might want. Sadly, they don’t.
March 16th, 2009 at 2:16 pm
This was an excellent column. I’ve been arguing for some time that while the Rating Agencies certainly acted in a corrupt manner, the real problem is the dependence of regulations on them and the government protection of them. They could potentially provide value in some manner if only they were allowed to earn their reputation themselves.
March 16th, 2009 at 2:22 pm
Ill repute doesn’t lead to mystical self-regulation by the market. For example, AIG is up 81.82% right this minute, and their reputation is for shit. Everybody knows that this criminal cabal is stealing money (thus, they have created. if not earned, a reputation for themselves), yet new money keeps coming in. Crazy days.
March 16th, 2009 at 2:32 pm
This is better news. Help for small business, as well as big ones like GM, is essential to avoid huge increases in unemployment. This $15B will be better spent than the John Thain and AIG bonuses.
http://news.yahoo.com/s/ap/20090316/ap_on_go_pr_wh/obama_economy
Speaking of Thain, Bernie needs a roomie at the MCC.
March 16th, 2009 at 4:28 pm
Its_Science,
it was excellent article, save for the timing. as BR points out, in the post, these problems have been known for over a decade. The MSM should get a little credit, as watchdog, for barking, now, after the household has been stripped bare. Actually, it’s ‘woofing’ at this late date should signal something else afoot–namely, in this case, the push for “Global Regulation, Regulatory Bodies”..
~~
“What’s there to steal now? I’m at a loss to figure it out.”–dh
see: SmartGrids, Solar Panels, Wind Farms, y mas..
LSS: namely those things that, w/o your subsidizing it, make no Financial sense, and, usually, little Economic sense..