When Agencies Get it Wrong, They Reeeeeeeeeeeeeeeeeealy Get it Wrong

We ended the first day of the conference with management professors, Professor Gerry McNamara (Michigan State University) and Professor Paul M. Vaaler (University of Minnesota). They discussed How and Why Credit Assessors "Get It Wrong" when Judging the Risk of Borrowers: Past and Present Evidence at Home and Abroad. Professor Vaaler observed that the subprime meltdown is just one of the latest mistakes the rating agencies have made in recent times (he also points to the S&L crisis, Asian financial crisis). He argues, however, that private, credit rating agencies are at the center of the current housing crisis.

Professor Vaaler stressed that the agencies almost always get it right when assessing the risk posed by individual securities. But, when they get it wrong they get it wrong in a spectacular way.

Professor McNamara discussed the factors that generally skew expert credit assessments. Relying on behavioral decision research, he noted that credit assessors often fall prey to "fads and fashions" even though lenders say they make lending decisions because of predictability. Thus, he found they made lending decisions based on new types of lending opportunities (new borrowers, for example), rather than sticking with the ones they successfully made in the past. Professor McNamara also found that, when the riskiness of the borrower increased, rating agencies were slow to change the risk rating because of the behavioral tendency to judge a current event (or product) based on views you have formed about it in the past. In addition, the research indicates that rating agencies are prone to jump on the bandwagon and adopt the positive views of a borrower others have adopted in the market even if current events suggest that the borrower or the security should be downgraded.

Professor McNamara also observed that rating agencies make mistakes because of factors having nothing to do with risk. For example, agencies that specialized in certain regions of the world tend to favor industries in that region, and become somewhat complacent in judging the risks in industries in those regions. Established rating agencies also tended to give out more favorable ratings (perhaps to curry favor?) while newer/insurgent rating agencies tended to be tougher raters.

Perhaps more troubling, although politics and international lending shouldn’t automatically affect a rating agency’s assessment of a sovereign’s creditworthiness, Professor McNamara suggested that political heuristics impact how agencies rate risks and that market rivalry affects their decisions as well. Using as an example the decisionmaking process agencies use to rate sovereign bonds, he posited that if there is uncertainty in a sovereign’s political structure (for example, an upcoming contested election) rating agencies tend to downgrade the debt. But, the amount of the downgrade is moderated if other agencies also have been asked to rate the bond. Thus, the data indicate that if more than one agency rates the sovereign in an election year, the downgrade is not as dramatic as it would be if there is little competition between the rating agencies.

Professor Steven Schwarcz (Duke) opened his response by suggesting that the term "agency" is itself a misnomer, since raters are not official "agencies" and are instead just private entities. He agreed that agencies mostly get it right, and added that they provide a valuable service only because of their reputation to get it right. If they continue to get it wrong, Professor Schwarcz surmised, agencies may soon find that their utility in the market will plummet.

Professor Schwarcz argues that rating agencies may not be as objective as they (and investors) may think they are. He stressed that investors should rely more on their own internal risk assessments, though they often rely exclusively on rating agencies. While Professor Schwarcz thinks rating agencies should be cautious in downgrading a company’s debt (largely because the downgrade itself may trigger a financial crisis or bankruptcy), he also thinks it’s risky for investors to rely on rating agencies. One problem, he noted, is that rating agencies don’t rate for fraud so relying on the agency’s rating to alert you to a company’s fraudulent behavior (can you say Enron?) would be futile.

Professor Schwarcz then addressed the recent failure of agency models to (timely) downgrade the ratings of subprime mortgage securities. He blames that failure in part on certain behavioral biases. For one, the availability bias may have caused raters to avoid downgrading subprime debt because they assumed that, since housing prices had appreciated for so long, house prices could never fall as spectacularly as they did. In addition, because of the sheer complexity of some mortgage-backed securities, some rating agencies might just have "goofed" by not properly assessing the risks. He also discussed the inherent conflicts of interest agencies have, since they now make money by rating debts (not by selling subscriptions, as had been their practice in the past).

Comments

[Mike Dillon]

I think the last sentence here is the key. Ratings agencies are PAID to rate securities - upfront if I'm not mistaken. That being the case, why would the ratings agencies want to bite the hands that feed them by issuing anything resembling negative ratings until/unless it became absolutely obvious - as it has within the last year - that the ratings were, at best, severely incorrect and, at worst, fraudulent?

The fact that the servicers are given things like late fees, modification fees, assumption fees, force placed insurance fees, REO "excess", etc. per the RMBS PSAs means that there is simply no incentive for servicers to keep borrowers current in their loans. Now, if the RMBS can get top notch ratings on those RMBS and get investors to sink big money into them, so much the better. And to do that you need to talk to the ratings agencies...

I'm willing to bet that there are a LOT of well-manicured nails in the lending/servicing/securitizing/rating industries given all of the mutual back scratching that must be going on....