Paul Krugman:Berating the Raters

[cal04]

http://www.nytimes.com/2010/04/26/opinion/26krugman.html

Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.

That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.

No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.

What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

(snip)
An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University. They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.

[muriel_volestrangler]

1. K&R

This was an essential problem in the sup-prime crash, and a proper fix is vital for future economic stability.

[WillyT]

2. Big K & R !!! - Plus... More Here:

Link: http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x8213915

:kick:

:hi:

[DCBob]

3. Totally agree. The rating brureaus carry much of the blame..

This needs to get more press. And unbelievabley there is nothing in the fin/reg bill about this.. AFAIK.

[unblock]

4. there are so many problems with the way ratings are done AND USED i don't know where to begin

krugman's cites that 93% of the aaa-rated subprime mortgages as evidence of something flawed in the ratings.
shocking as that number appears, it's not a strictly valid conclusion (not, at least, based on the limited info krugman supplies).

a aaa rating simply means the chance of default is very small, let's say 0.5% (i don't know what the exact number is theoretically supposed to be, but the rating agencies essentially have a target percentage in mind that corresponds to each rating level. note that this is a percentage chance of default, i.e., losing at least ONE PENNY of principal. it says nothing about the upside or lack thereof, and it says nothing about the AMOUNT of default (that's called "severity", and it generally does not enter into the rating methodologies.

there is NOTHING in this that says that the ratings and probabilities of defaults of many different securities are unrelated. in fact, one should expect common causes to affect a large number of similar securities. ALL subprime mortgages are sensitive to falling home prices and therefore a crumbling real estate market should be expected to crush a larger percentage of subprime mortgage securities. and that's exactly what happened.

the rating agency logic was that the probability of real estate getting sufficiently hammered to cause all these defaults was less than 0.5%. how people are describing this as a once-in-a-century kind of financial event, maybe they weren't as far off as it appears.


all this said, the concept of a rating being based solely on probability of default is still.
the lack of sufficient competition (and inevitable near-perfect agreement on ratings among the few players) is rediculous.
the overreliance on ratings from a single source is silly.
the lack of due diligence outside of a rating is silly.
the ability of an issuer to shop around for a rating is silly.
the fact that the money for the rating comes from the issuer is silly.

what a mess!

i could go on....

[WillyT]

5. Kick !!!

:kick:

[TheKentuckian]

6. K&R the ratings agencies need a complete overhaul

and the absence of dealing with the matter is a sign of bad faith in dealing with financial reform. The banks not only pay the rating agencies but pick and choose who to give them favorable reviews.

Half measures are by definition worthless in this battle. Its time to be very committed to no bullshit.