I was watching Sal Khan’s video on credit default swaps and was thinking about the problems with CDS’s. He points out that a ratings agency like Moody’s would give a high rating to a company like AIG allowing them to insure various bonds to bring them up to investment quality. He points out that because Moody’s is paid by AIG to rate them, they have an incentive to overrate them. He further points out that they are allowed to insure debt in excess of their reserve capital so that if they underestimate the risk of a particular bond, they might become undercapitalized causing a downgrade, thereby forcing a beneficiary who is, say, required to only invest in companies above a certain rating to liquidate that insured debt, terminating a revenue stream to AIG, etc., causing Warren Buffett to label derivatives a “financial weapon of mass destruction”.
So, what to do about this? Ideally, a ratings agency would have no incentive to overrate a company, although that isn’t necessary in his scenario to cause the whole thing to come crashing down. He doesn’t exactly suggest that the gov’t be in charge of ratings, but he does seem to say that he thinks that they would be impartial. I don’t believe that government agencies are immune to political pressure and so I have trouble believing that ratings should be a government function. It seems to me that it should be that the investors would somehow pay the ratings agencies thereby giving them the incentive to be impartial. I am not sure how that would work and there are probably holes in the idea that haven’t occurred to me.
The other issue that he points out is that an insurer can become undercapitalized which I presume might happen because they fail to adequately assess the risk on a bond leading to all the B.S. that I mentioned in the first paragraph. I thought that perhaps insurers should be required to carry something akin to deposit insurance, After all, a bank’s reserve capital requirement is (I think) only 10%. The FDIC insures accounts to inspire confidence in banks and prevent runs. But then it occurred to me that the insurer is protected against runs by the fact that beneficiaries can’t get their benefits on demand like depositors can. We (well at least I) don’t want to ban derivatives outright because of their stabilizing effect on prices. I don’t know that credit default swaps are a Bad Thing and should be outlawed. I am up a stump on this one.
How do we close the barn door, admittedly after the cow got out, on this sort of thing?
You kind of muddle together some words like guarantee and CDS but I will assume you are referring to CDS’s in their role as guarantees on other debt (credit support).
Reserves don’t have to equal or exceed total potential liability for the guarantor to maintain a good credit rating. The notion is that all the debt isn’t going to go bad at once (of course it did) so you risk weight the reserve requirements so in order to maintain your rating you might have to have reserves equal to 5% of the AAA debt that you guarantee (I’m totally making these numbers up) and 15% of the AA stuff you guarantee and 50% of the BBB stuff you guarantee.
A downgrade in AIG’s credit rating doesn’t always terminate AIG’s revenue stream, it increases their cost of borrowing but it doesn’t hurt AIG if someone sells debt guarnateed by AIG. What hurts is that the terms of the debt sometimes require that the guarnator maintain a minimum credit rating so if AIG credit rating drops below a certain level, the folks who are paying AIG for their guarnatee will get a different guarnator but it was not the loss of these guarnatee fees taht killed AIG.
What killed AIG is that the swaps all went south at the same time and AIG didn’t have enough capital to pay the variation margin on all of them. What killed them was paying off on these guarantees/CDS.
Well there are a few ideas floating around. One idea (which I believe is part of Dodd/Frank) is to have all CDS’s traded on a single exchange/clearinghouse that would maintain capital requirements for all parties and the exchange/clearinghouse would be the one that pays for all ratings. The clearinghouse is presumably more concerned about the accuracy of the credit rating considering that the clearinghouse ends up being the guarantor of the entire market and would reward good analysis over high credit ratings.
Most insurance companies are underwritten by the states in which they do business in an FDIC sort of way and the insurance commissioners enforce reserve requirements to make sure they can pay all claims as they become due. Some states have made attempts to apply this to financial insurance as well (NYS considered regulating CDS like insurance at one point).
I think that a clearinghouse system would probably address most fo your concerns in this area.
Once again I think that the clearinghouse model addresses most of your concerns.
Interesting. I will have to find out more about this clearing house. Sorry if I placed equivalence on some terms there that are not equal. Regarding AIG though, are you saying that they were the victim of a perfect storm? Do you feel that they should have seen it coming?
It’s not just that they got hit by a perfect storm (which to some extent we all did but WE seeded the clouds and lined up a bunch of thing that would come crashing down under a strong breeze. Being on the guarantor side of credit default swaps has been likened to picking up pennies in front of a steamroller. AIG was doing so with it’s shoelaces untied.
A lot has been made about this supposed conflict of interest, and I agree there is sort of a point to it; however, it’s really not that simple. Look at an analogous situation in the same general market.
When you try to get a home loan from a bank, they require you to get an appraisal. The bank basically chooses which appraiser to use and you pay the cost of the appraisal. Now, did the appraiser have a conflict of interest to give you a high appraisal because you are paying the bill? No, of course not. They are trying to make the bank happy not you even though you are the one paying them.
Similarly, a company hires Moody’s to rate the debt because it is required to by the investors. Just because the company is paying the bills doesn’t mean Moody’s has an incentive to be biased in favor of the company. If the investors lose confidence in the value of Moody’s ratings, they will stop requiring that as a condition to investing.
The real problem is that Moody’s (and the other major ratings agencies) is very good at rating some things and not very good at rating other things. The things it is not very good at rating are, not surprisingly, difficult to analyze. Also, the rating agencies are notoriously slow to revise ratings. On the corporate side, Moody’s KMV ratings seem to be a better predictor of default than the normal Moody’s ratings. However, this could simply be because it relies so heavily on the market value of equity and the movement of stock price is a pretty decent indicator of default risk.
Big insurance started with ships, a key idea being that the ocean didn’t have a single giant plug that would cause many ships to sink at once.
That loans in a single economy could, unlike ships in an ocean, be strongly correlated should have been obvious to anyone with a brain.
It gets worse. The AIG unit insuring bonds showed large profits for a few years and, somehow ignoring that those “profits” needed to be held as reserve against a future day of reckoning, a large portion of those profits were paid out as bonuses to the CDS brokers and traders. :smack: (Admittedly, those bonuses, while totaling several Billions of dollars, would not have been sufficient to cover the eventual losses.)
I won’t detail measures to prevent future recurrence except to note that the first step is to admit there was a problem. Many financiers and politicians still seem to be in denial about that.
I don’t know tha the lenders always choose the appraiser or if someone involved in the transaction can choose the appraiser off an approved list but the bank exercised the majority of the discretion. In what way are the ultimate investors in mortgage securities exercising any discretion on who the “appraiser” will be?
I don’t think your appraiser analogy is as accurate as it could be. Imagine if the lender was choosing the appraiser with the certain knowledge that they would sell the mortgage the day after it was closed. Does that change the calculus for the appraiser? What if you were making more money in one year during the boom than you made in the last ten years of the last century combined?
I think that a lot of ratings agencies saw more money in the last ten years from rating all these tranches than they had ever seen before and it turned their heads.