Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Moody’s archaeology is quite unconvincing

Last week, Moody’s published a report on the global credit
crisis (Archaeology
of the Crisis
) that I found totally unconvincing. To begin with,
the word “archaeology” in relation to such a recent event
is perplexing, but that is a minor issue.

My most serious disagreement is with the section in the report on
“Reduced risk traceability in the financial innovation
process”. Moody’s argue:

Rating agencies were supposed to bridge some of the information
asymmetries, but this proved to be some-what unrealistic when the
incentive structure of (sub-prime) loan originators, subprime loan
borrowers, and market intermediaries also shifted in favour of less
information.

… The problem in the case of extreme complexity of inter-connecting
financial systems is that it is hard to see how the level of
information could reach levels adequate to enable reasonable risk
management standards.

Risk traceability has declined, probably forever. It is extremely
unlikely that in today’s markets we will ever know on a timely basis
where every risk lies.

This leads to two conclusions. First, more capital buffers will be
needed or required by counterparties and regulators. Second, not just
more but more intelligible information is needed …

Moody’ is trying to argue that rating agencies failed because
the task that they were asked to do was impossible. The first problem
with this argument is that they should have thought about this before
they accepted the rating assignment and collected their fees. The
second problem is that the solution of greater capital buffers (higher
attachment points for various rated tranches) was available to the
rating agencies all along, but they chose not to go this route.

The third problem with Moody’ argument is that it is becoming
increasingly clear that the credit crisis that we are seeing today has
nothing to do with financial innovation but is more like the familiar
credit and banking crises of the past. For example, it is quite
similar to the Japanese banking crisis of the 1990s which also had its
origins in a property market collapse.

In August of 2007, it was possible to argue that the credit crisis
was somehow related to the difficulty of valuing complex financial
instruments like CDOs. One might have thought that credit correlations
(which are difficult to estimate) might have been underestimated but
there was no problem with the core credit assessment. However, the
fall in prices of sub prime linked instruments has been so steep and
persistent that it is now clear that the issue is not about
correlations but about the value of the underlying credit. A good deal
of this underlying value depends on macroeconomic variables like
housing prices and GDP growth where there is little if any information
asymmetry.

Today, the rating agencies can really take one of only two
positions. Either they can admit that they made a grave error in
estimating credit risk in a whole large class of credits without any
significant attenuating circumstances. Or they can argue that the
markets have got it all wrong and the credit quality of sub prime and
alt-A housing loans is not as bad as the market thinks. With every
passing week of new data coming in from the US, the second position
looks increasingly untenable.

In 2001, when the rating agencies were severely criticized for
their failures in relation to Enron, I argued
that the most that one could accuse them of was some degree of
complacence. I wrote: “Any criticism about the rating agencies
must keep in mind that the agencies gave Enron a rating that reflected
a high level of risk.” Moreover, there were significant
information asymmetries between the rating agencies and Enron. The
asymmetries in sub prime lending were much lower and the rating
agencies had the law of large numbers on their side. I think therefore
that a mea culpa would be more appropriate than the kind of
archaeological sophistry that Moody’s has dished out to us.

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