Larry Summers’ Unanswered Questions

Today, in a comment at the Financial Times, “This is where Freddie and Fannie step in” (subscription required), Harvard’s Larry Summers argued that the subprime crisis highlights three questions. Most commentators focused on the one question he not only posed but answered, namely, what role government should play in aiding the flow of credit to the housing sector. Summary: while Summers is dubious about the wisdom of how Freddie Mac, Fannie Mae et al. have operated, he thinks they have a legitimate role when to play when mortgage funding becomes scarce.

I find Summers’ unanswered questions more interesting:

First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default. There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that – as in previous financial crises involving Mexico, Asia and Enron – the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? What is the alternative? Sarbanes-Oxley was a possibly flawed response to the problems Enron highlighted in corporate accounting. What, if any, legislative response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial institutions? A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve’s payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments. Central banks that seek to instill confidence by lending to banks, or reducing their cost of borrowing, may, as the saying goes, be pushing on a string. Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?

To Summers’ first question on what to do about the rating agencies, the answer is that the options are few and not very attractive. You can’t get rid of ratings and you can’t get rid of the rating agencies we have.

Credit ratings are tightly wound into regulations and investment processes. Ratings are used in domestic and international bank capital adequacy standards, pension fund and insurance investment standards, even in the Fed’s definition of acceptable types of collateral for discount window purposes. Similarly, credit ratings are fundamental to bond pricing. Traders and investors routinely look at the spread over Treasuries, that is the number of basis points over the comparable risk-free rate investors are paying to assume a certain level of credit risk.

If we were to get rid of credit ratings, we’d have to replace them with something that served exactly the same function.

Similarly, like it or not, we are stuck with our current rating agencies. In the wake of 2002 corporate accounting scandals, some large accounting firms had to be allowed to survive, no matter how bad their malfeasance proved to be, because the workings of our capitalist system require audits of large companies, and only large accounting firms can perform that function. Smaller firms could not step into that breach.

Ditto the rating agencies, except what will prove more galling as this sorry sage progresses is that the rating agencies are so few in number, which has the effect of giving them a free pass. We cannot afford to have a public execution of one of them to satisfy the public’s need for justice and instill a little fear into the others. Any legislation that provided for penalties even an order of magnitude lower than the losses they caused would put them all out of business.

Accordingly, Summers mentioned Sarbox. The best policymakers can do is give the rating agencies tougher guidelines, restrict them from playing a quasi-underwriting role (they worked fist in glove with investment bankers in structuring asset backed securities) and perhaps establish much greater penalties for issuers that provide incomplete or misleading data to rating agencies. All in all, not a very satisfactory solution.

Summers’ second question is worded oddly (“how should policymakers address crises centred on non-financial institutions?”) I think he means “financial non-institutions”, players that are not subject to oversight by the Fed or the Office of the Comptroller of the Currency but whose actions can and do have a big impact on regulated banks. That isn’t just hedge funds. Investment banks, which are regulated by the SEC, can also tank the banking system (that’s precisely why the Fed rounded up 24 firms, most of which were not under its regulatory oversight, to stem the collapse of LTCM).

Another way to put it is that financial intermediation used to happen almost entirely through the banking system. Individuals and companies put their deposits with banks, which then used them to make loans. Only very big companies used the capital markets for debt finance.

But since 1980, banks have been losing market share in financial intermediation to investment banks. US banks now hold only 15% of non-farm financial debt.

Now recall that the banking regulators oversee players that have become more and more peripheral over the last 25 years. Note that this limited scope impedes their understanding. The Fed kept assuring the public that the Brave New World of financial innovation was working just fine. What basis could they have had for such rosy views?

For example, in a March 2007 speech, New York Fed president Timothy Geithner essentially admitted the Fed and other regulators lacked a complete, or even good, picture of what was happening. His argument boiled down to,”Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK.” This quote was telling:

….these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.

Those fat tails will get you every time.

The good news, is, as Summers stressed, these issues are now on the table. Regulation will increasingly be seen as necessary and desirable, so long as it is not done to excess.

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  1. Martin

    But what about delinking the “pay for play” aspect of the ratings game, or as one bond trader I know called it, “rating shopping?”

  2. Anonymous

    Anyone who has dealt with the ratings agencies know that they are often the dumbest people in the deal — unless it’s the monoline insurance companies (the “wrappers”).

    There’s a structural problem. Ratings agencies pay less than I-banks. Rating agency folks have wide exposure to all the I-banks. Good rating agency folks are quickly hired away to better paying jobs at I-banks. So folks who stay at ratings agencies a long time are often incompetent or lazy or have a personality defect or… I wish I was kidding.

  3. Yves Smith

    In theory, that would help, but I see the problems as bigger and more deeply rooted.

    Basically, with these new-fangled products, some academics have found evidence of rating agency incompetence as well as having been co-opted. Remember, they get paid by both sides: by the entity being rated and by investors buying their research and analytical tools.

    And in practice, I’m not certain you could prove, and therefore prevent, rating shopping. After all, it’s reasonable for an issuer to have an idea of how his fancy new product might be rated. He might need to restructure it, or might decide not to proceed altogether (that is, the rating is an important component of marketability, so it’s reasonable for issuers to assess the marketability of a deal before proceeding). And since you generally want more than one rating (some investors require that), it’s also reasonable to call more than one agency to make sure the one you spoke to doesn’t differ wildly from the others.

    Now of course, we all know that the other agencies are loath to second-guess the agency that got into the guts of the deal to do the initial rating, if it’s a structured product…..But as you imply, this leads to a race to the bottom.

  4. Yves Smith

    If you are a glutton for punishment, we’ve written quite a bit on the problems with rating agencies Including the talent, or lack thereof, issue mentioned by Anon of 9:12 PM. This is a partial list:

    If you have patience for only one, this one has some pretty damning stuff not widely reported elsewhere:

  5. LJR

    A common way to ameliorate abuse of privilege is to force the actors to have some skin in the game. If a ratings agency is going to have financial interest in structuring debt instruments then let’s legislate the requirement that it purchase enough insurance to cover at least some of the losses should they occur.

    In other words: make the cost of failure high enough to be excruciatingly painful but not enough to bankrupt.

    Call it the Prometheus solution. We’ll peck their innards out by day and let them regrow at night. Die they shall not.

    One or two incidents would probably make the ratings agencies far more conservative. The cost of purchasing CDS’ on their structured products would skyrocket.

    The fundamental problem is that the legitimate role of money – to coordinate and motivate human endeavor in productive ways – has been usurped and betrayed. What remains is a hopelessly labyrinthian maze of computational complexity resulting only in the enrichment of those who add nothing to the well being of the world.

    I recently read that as of May 78% of financial assets were derivatives vs: 11% in the stocks and 1% in cash. What happens when 15% of those derivative holders panic and want value they can hold in the palm of their hand?

    What a mess.

  6. Anonymous

    I disagree with the anonymous investment banker above who says the rating agency analysts are typically the “dumbest” in the room. It’s typical of a banker to (i) swashbuckle so arrogantly and (ii) imply that intelligence has much to do with the spreadsheeting and suck-up salesmanship that constitutes 90% of their vastly overcompensated labor — overcompensation based, manifestly, on the biggest price fix in the business world.

    And no, I’m not now and never have been a rating agency analyst. But I’ve drafted many a CDO for a living, have been on many calls with the bankers and agency analysts, and offer the following observations:

    — the agencies are overworked and underpaid,

    — the so-called bankers handling the deals are typically late 20s, early 30s muscleheads in tight suits

    — they have no care for the public effects of their dealmongering, caring only to close the deal;

    — they connive routinely, sometimes with their lawyers but often behind the lawyers’ backs, to exploit loopholes or otherwise undermine the good-faith work of the agency analysts;

    — they consider their dealmongering a matter of wrestling with the party on the other side of the trade — a kind of jockish jousting — and may the most devious man win, blind, one might think, to the public good and the existence of public consequences of their play.

    A now-senior investment banker, overhearing literary chat in a conference room, asked “Is your novel fiction?” Followup chat revealed he had passed through high school, college and business school — fancy shops, too — without ever having encountered a novel.

    To think that institutions operated by such people can be relied upon to conduct public affairs in accordance with the spirit of the securities laws is foolhardy.

    Regulating these demi-beasts in tight suits will remain work of the agencies.

    The most practical way to reform the agency system, given where we are, may be:

    (i) instead of a bank paying an agency directly at the closing of a deal, funnel the money from the bank into a central kitty;

    (ii) then pay the agencies monthly, say, from the kitty, based (as now) on the volume of their work.

    The banks/issuers would still be paying the fee. But the direct pressure upon an agency to “perform” on a deal-by-deal basis would largely be relieved.

  7. Yves Smith

    Anon of 1:22 AM,

    Thanks for the comment and good suggestion. It has the effect of treating the agencies like a public utility, which in many ways they are.

  8. a

    The previous suggestion is unworkable unless the ratings agencies become international rather than (as they are now) American. Europeans would have a hard time justifying taxing their investment banks to the benefit of a company which is subject only to American law.

    In any case I think it’s far better to take the ratings agencies for what they are: capable of offering guidance based on historical statistics. That means ratings agencies are capable of providing ratings for plain vanilla products where historical statistics are present and relevant. For more complicated products they should not be allowed to provide ratings, or, if they do provide them, these ratings should be asterisked in some way so that they can be treated differently than the plain-vanilla products. After that, it is buyer beware. If this grinds the market for the exotic products to a halt, too bad for them; but if that were to happen, then it is clear these exotic products only have managed to exist because one a confusion as to what their ratings mean.

  9. Anonymous

    All comments seems to assume, the current capitalist system of finance is the only workable system.
    Think about the possibility of delinking Wall Street, the casino, from Main Street, the actual value added producer. All this finance theory of risk mitigation through market play is no more the foolery by Tom Thumb.
    As for I-bankers, Fund-Managers, Rating Agencies et.el, did they create value or destroyed value ?

  10. Anonymous

    Summers says “First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default.”

    Are we talking MBS, ,CDOs, or ABCP here? Is this true and, or, really the cause of the crisis? Elsewhere I have seen the comment that AAAs have not yet been impacted by losses.

    Do not re-ratings happen thick and fast in corporates too?

  11. Yves Smith

    Anon of 2:22 PM

    For what it’s worth, I noticed this was a particularly poorly written piece. Dunno if Summers got it in late, or the guy at FT who was editing him was the end-of-summer stand-in and afraid to mess with a big name.

    The line you mentioned does go a bit overboard. However, from everything I can tell (and people like me don’t sit on trading desks), ABCP is just not being purchased. That doesn’t (necessarily) have to do with fear of losses, but that it’s value could go down due to everyone else repudiating it. Remember, a big chunk of buyers are subject to $1 NAV rules. They can’t take principal losses on their portfolios.

    As for CDOs, I have seen comments that on some deals the losses couldget so large that they even impair the AAA tranche (see Fitch said privately with 1-2% price declines, “their models break down” and you’d see impairment extend into the AA and AAA tranches.

    So the worries are legitimate…..

    Anon of 1:40 AM and a at 7:08 AM

    Note that Anon proposed a change in the payment mechanism, not a tax. However, that still might be unacceptable to Europeans.

  12. Laurent GUERBY

    A question I have on rating agencies: do they have access to non disclosed to the public information?

    For me if they have, rating will never work.

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