Among the storylines that seem widely accepted surrounding the financial crisis is one concerning the ratings agencies. These are the businesses that evaluate and assign grades to securites (e.g. AAA, AA, etc.).
The standard narrative goes something like this: Investement banks like Goldman Sachs had a pile of mortgages that they wanted to "securitize" they would then bundle them all together and sell shares of the bundle. They would then make money selling the shares. One of the things they would do before they sold the shares is take them to a rating agency and get a grade. They would, of course, try to get the highest grade of AAA whenever possible. It was the investment banks that paid the ratings agencies for the service of grading. Therefore, the story goes, they were buying good grades. So instead of acting as an impartial judge of quality, the ratings agencies were "bought" by the fees they received.
It's a nice story, but maybe not the whole picture.
The fact of the matter is that it is the buyers of the securities (the shares in the pools of mortgage) that benefit from the high grades. Many buyers are institutional investors and they are governed by rules about what type of securities they can hold. Investors like pension funds are in some cases required by law to hold AAA securities. There are also regulations about how much leverage (borrowing) an investment fund can do based on the grades of the securities that it holds.
Buyers of these securities were in need of places to invest their funds that also fit the regulatory criteria to which they were subject, so they were the ones to benefit from the grade inflation just as much, if not more so, than the sellers of the securities. Even in cases where one of the rating agencies provided the highest rating and another did not, buyers of these securities didn't seem to be troubled by the conflicting signals. They had their AAA and that is what they needed. If things went sour, they could point to that as some proof of their diligence in money management, and we can all see how well that strategy has worked.
This is not to say that acts of sloppiness and perhaps even fraud didn't occur at the ratings agencies; it would be more shocking if they didn't. Taking the time to think through where the incentives lie and who was in the position to inject some sanity into the market can help shed some much needed light on these problems.
This notion of the ratings agencies and the buyer's incentives, comes from an episode of EconTalk featuring Charles Calomiris of Columbia. You can listen to the podcast or read a transcipt at econtalk.org. The ratings agency discussion comes at about 54 minutes.
Update - I was thinking about this after reading this post at Dad29. I should have linked it before, but didn't.
The standard narrative goes something like this: Investement banks like Goldman Sachs had a pile of mortgages that they wanted to "securitize" they would then bundle them all together and sell shares of the bundle. They would then make money selling the shares. One of the things they would do before they sold the shares is take them to a rating agency and get a grade. They would, of course, try to get the highest grade of AAA whenever possible. It was the investment banks that paid the ratings agencies for the service of grading. Therefore, the story goes, they were buying good grades. So instead of acting as an impartial judge of quality, the ratings agencies were "bought" by the fees they received.
It's a nice story, but maybe not the whole picture.
The fact of the matter is that it is the buyers of the securities (the shares in the pools of mortgage) that benefit from the high grades. Many buyers are institutional investors and they are governed by rules about what type of securities they can hold. Investors like pension funds are in some cases required by law to hold AAA securities. There are also regulations about how much leverage (borrowing) an investment fund can do based on the grades of the securities that it holds.
Buyers of these securities were in need of places to invest their funds that also fit the regulatory criteria to which they were subject, so they were the ones to benefit from the grade inflation just as much, if not more so, than the sellers of the securities. Even in cases where one of the rating agencies provided the highest rating and another did not, buyers of these securities didn't seem to be troubled by the conflicting signals. They had their AAA and that is what they needed. If things went sour, they could point to that as some proof of their diligence in money management, and we can all see how well that strategy has worked.
This is not to say that acts of sloppiness and perhaps even fraud didn't occur at the ratings agencies; it would be more shocking if they didn't. Taking the time to think through where the incentives lie and who was in the position to inject some sanity into the market can help shed some much needed light on these problems.
This notion of the ratings agencies and the buyer's incentives, comes from an episode of EconTalk featuring Charles Calomiris of Columbia. You can listen to the podcast or read a transcipt at econtalk.org. The ratings agency discussion comes at about 54 minutes.
Update - I was thinking about this after reading this post at Dad29. I should have linked it before, but didn't.
1 comment:
Hmmmn.
Buyers and sellers both!
Sweet...
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