How to reduce the risk of future black swans: eliminate issuer-paid ratings
The following is a guest post by Kenneth Posner, author of “Stalking the Black Swan: Research & Decision-making in a World of Extreme Volatility.” The opinions expressed are his own.
Recently, the U.S. Financial Crisis Inquiry Commission (FCIC) held hearings on the role of the rating agencies in the near-death experience of the U.S. financial system, an important topic given the disastrous performance of mortgage-backed securities rated AAA by Moody’s and Standard & Poors.
The problem with the rating agencies is not their role, but the oligopolistic domination of the business by these two firms. This domination is a direct result of the “issuer-paid model” under which rating agencies are paid by the issuers of securities, rather than investors.
To reduce the risk of future crisis, we should eliminate the issuer-paid model, returning the rating agencies to their roots as investor-paid businesses. This reform would create room for a larger number of rating agencies, restore incentives for quality and accuracy, and encourage more prudent decision-making by investors, regulators, and financial institutions.
Investor-paid is a viable business model, as one-third of Moody’s revenues during 2008-9 came from subscription fees for research, data, analytics, and risk management software, with healthy margins in excess of 40%. (The other two-thirds of revenue came from issuer-paid ratings).
The housing bust, capital markets crash, and economic downturn we have gone through is an example of a “black swan,” the term popularized by Nassim Taleb for seemingly unpredictable events of extreme impact. One cause of black swans is excessive financial leverage. Other causes are more subtle. When many people share the same belief or follow the same decision-making process, the system becomes highly leveraged to the resulting consensus view. If proved wrong, the readjustment can be wrenching.
For example, Americans have long believed in the stability of home values. Indeed our cultural commitment to housing forms part of the “American Dream.” At the FCIC hearing, Warren Buffett said it well: “300 million Americans believed home prices could not fall.”
Another mass belief that contributed to our crisis was the notion that the Federal Reserve could forestall economic crisis by cutting interest rates. This was known as the “Greenspan put,” and it may have contributed to excessive risk-taking among investors and financial institutions.
Other widely-held beliefs arise when many people follow similar decision-making processes. For example, most financial institutions use similar statistical models to manage risk, and regulators use the same models to set capital requirements. Based on historical data, these models indicated that mortgages had low risk, and under this widely-shared view, financial institutions poured too much capital into the asset class.
The rating agencies are in the business of producing widely-shared beliefs called “ratings.” Many investors rely on these ratings. According to Professor of Law and Finance Frank Partnoy at San Diego University School of Law, ratings have become incorporated into regulations covering securities, pensions, banks, insurance companies, and broker dealers.
Some institutional investors can only invest in securities with investment-grade ratings, others are protected from lawsuits if they stick to AAA-rated securities. With so many decisions resting on their ratings, Moody’s and Standard & Poors have become a source of enormous leverage in the financial system.
To be sure, there is value in the rating agencies’ work, just as there is value in moderate amounts of financial leverage. Rating agencies save investors the time and cost of analyzing huge volumes of data, most of which would be duplicative and wasted effort.
But our financial system would be stronger if there were a larger number of rating agencies that competed on the basis of quality and accuracy.