Wednesday, December 24, 2008

Market Insanity?

CIP sees the madness of crowds in this vignette of the financial industry debacle. I disagree. Some excerpts:

To illustrate what was going on with the ratings agencies, Millman provides a simpler to understand example, the CPDO:
The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

How did a market that, I thought, had really helped capitalism work in 2002 become the great destroyer of capitalism of the last two years? There were a lot of contributors to the catastrophe, but one indispensable one is that the ratings agencies monetized their sterling reputations in an extraordinary fashion, and nobody in regulatory apparatus of government saw that this was happening, and what it might portend. The success of 2002 depended on market confidence in the ratings agency process: that’s what made investors willing to buy the notes issued by structured finance vehicles that issued the credit protection that made it possible for banks to hedge. Without that confidence, the market would never have developed. And by 2006, the agencies understood just how much that confidence was worth.

The ratings agencies have an enormous amount of power: pension funds and insurance companies invest according to their rules; under Basel II, bank capital ratios are substantially determined by how the agencies rate their portfolios of loans; and, of course, the entire “shadow banking system” created by providers of super-senior credit protection (monoline insurers, bank-sponsored asset-backed conduits, AIG Financial Products, etc) was only possible because of the ratings agencies. By 2006, the entire financial system was extraordinarily leveraged to the opinions of these government-blessed non-governmental independent agencies, and these agencies were monetizing their market position by trashing their process.

This is not the madness of crowds. Nor is this human error. There is no simpler words for it than "these agencies were monetizing their market position by trashing their process".

The results?
...the market has lost any reason for confidence in the agencies in both directions: they cannot be trusted when the market is strong to assess the downside risks the market is ignoring, and they cannot be trusted when the market is weak to assess a company’s financial condition independently of the market panic.....

Right now, we’re in the low-trust environment that is the reality when the libertarian fantasy of eliminating the market-distorting regulators actually comes to pass. The market is inevitably focused on a short time horizon, fickle and volatile by its very nature. We want major financial institutions – banks, insurers, etc. – to look beyond the market to longer term risk metrics. Without the agencies as an independent arbiter of what these might be, the market is all we have left. Trust is a very hard thing to rebuild, and structural changes – having the agencies be government-sponsored, or paid by investors rather than issuers – are insufficient solutions (government-sponsored entities are also capable of seeking to monetize their position – look at Fannie Mae – and investor-sponsored agencies would be subject to the same pressures to facilitate the business that investors want to do).

We are still in a dark wood wandering, the right road lost.

The ratings agencies' misalignment of long-term interests and management actions is really not different from that of any American corporation, except of course, the effects are much more severe. It has always been rather obvious that a great reputation or brand name can be converted into (lots of cash + no reputation) in short order. There is always the perverse incentive of "take the money and run". Unless there is a strong counterincentive - people are going to take the money and run.


PS: I wonder whether tax policy would be a counterincentive. E.g., if CEOs were in the 90% marginal tax bracket, they would have more incentive to receive a lifetime of income from their companies, rather than to hit the jackpot in three years and then move on, leaving their companies trashed.