How to reduce the risk of future black swans: eliminate issuer-paid ratings

By Reuters Staff
July 1, 2010

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.

6 comments

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This article builds on the silly idea that you can prevent black swans, which is an absurd statement as part of the requirement of a black swan is that it is unpredictable.

The financial meltdown wasn’t a black swan, it was the logical outcome of the poor policy making of the last thirty years caused by Republicans and then Democrats falling in love with the idea of free markets, along with lowering taxes to the point where we can’t support the system that was in place for five decades before Reagan.

This was no surprise, this was reaping what you sow.

Posted by jstaf | Report as abusive

I totally agree with jstaf. I have 30 years of wall street expericne

Posted by seashell | Report as abusive

In business school one of my best professors had a great saying: “system efficency and system relibility are worthy but competeing goals.” And that is true of almost any system; financial, mechanical, electrical… you name it.

Want to make a car safer… add airbags, a steel safety cage, larger power breaks, power steering… whow wait a minute how come Tata motors can build a car for 1/4th the cost of the lowest priced american made car and 1/10th the price of the average american made car. Answer our laws and consumers mandate safety. That’s also why the average car built today gets exactly the same miles per gallon as the model T Ford.

Look at the american electric grid. Do you want 99.99% uptime or do you want lower electric rates.

In business you can:

A. build something cheap
B. build something fast
C. build something right

If you’re really sharp you get to pick 2 of the above… but not all 3.

Posted by y2kurtus | Report as abusive

As a side note gold is down forty dollars on the same day that JP Morgan Chase takes over Royal Bank of Scotland’s metal trading business and is made a ring member of the London Metal Exchange.

What a coincidence!

CFTC, you are a useless federal agency that serves no purpose other than to let the mega banks rob investors!

You along with your master JP Morgan Chase need to be abolished!

Posted by bigkirb71 | Report as abusive

I think the investors need better access to rating agencies since they are smaller individual units with separate investing interests and goals. The issuers can work as a collective entity with a large capital backing to pay for and organize the request for a rating, do the issuers have that kind of organization and unity? Maybe i dont understand how investor model works.

Posted by shaderbc | Report as abusive

@jstaf

The second part of Taleb’s point was that ex-post-facto, people engage in a fallacy of denying the existence of black swans by dwelling on the inevitability of the outcome given the (now obvious) causes. Sounds vaguely familiar…

In response to the article I have two issues: 1) it assigns an extraordinary weight to the ratings. while most professional credit investors do take note of ratings, the ultimate valuation of a security should come from the investors themselves not the ratings agency; 2) the solution of an investor-paid ratings system discounts the fact that given the premise of supply/demand there is much less incentive to rate small-cap names and transactions, creating yet another barrier to entry for small firms trying to access capital markets

Posted by donjl706 | Report as abusive