The Market is Dead! Long Live the Market!
Sudhir Venkatesh‘s book “Gang Leader for a Day,” originally published last January, is now out in paperback. You can read reviews of it here, here, and here; and The Economist named it a book of the year.
Robert Rosenkranz has proposed means of financial market regulation. His Wall Street Journal op-ed offers redress for the abysmal behavior of credit agencies, those once-heralded assessors of risk whose reputation now lies somewhere underneath a common garden snake. If you listen to public and media criticism, these agencies are more than partly responsible for mistakenly valuing the “worthiness” of various structured financial products that saturated the bond market in the past decade.
With some hubris, and a touch of brazenness, Rosenkranz says that we don’t need these agencies at all: get rid of all independent ratings, and let the market assess risk.
The credit worthiness of a bond rating is a letter grade of sorts — “AAA” being the most secure, “C” signaling substantial risk, and “D” being in default. Seven ratings agencies, recognized by the Nationally Recognized Statistical Ratings Organization and overseen by the SEC, grade various forms of corporate and public sector debt issuances, the most prominent being Moody’s, Standard and Poor’s, and Fitch. These firms have taken quite a hit recently for failing to measure risk responsibly and thereby providing investors effective counsel.
Rosenkranz says the rating agencies need not exist at all for investors to understand the risks of betting on various financial products. In his proposal, the market could function as an advertiser of risk by simply publicizing bond spreads: as the spreads widen, the risk grows. Q.E.D. And as the risks grow, so too does the obligation of the bond holder to shore up the note. Q.E.D. again.
He writes: “The amount of capital required to hold a fixed-income security should be determined not by a rating but by its yield, expressed as a spread over Treasurys. The higher the spread, the riskier the market has determined the asset to be, and more capital should be required to hold it.”
Whatever we think of the proposal, Rosencranz points to a structural imperfection in the ratings market — one that precludes true competition.
Think of it this way: why don’t more companies seek out the business of rating debt? The payouts for ratings agencies are not chicken feed. The market has grown enormously since the 1990’s. Where once ratings firms primarily counseled subscribers about the risks of fairly straightforward corporate debt, they now help issuers of debt attain AAA ratings. I use “help” advisedly, since we have learned how they coach their clients into presenting the products in such a way that “AAA” is almost a certainty. See, for example, Gretchen Morgenson‘s pithy assessment: “The woefully inaccurate ratings that have cost investors billions were not, mind you, a result of issuers paying ratings agencies handsomely for their rosy opinions …” Her writings in The Times have been some of the best.
The usual answer is that the top firms have built up decades of trust in the financial community. In non-crisis periods, it would be difficult for a newcomer to enter the ratings market because corporate boards seek out the top firms to legitimize their issues, pension fund managers look to these firms for seals of approval, and so on. But this could change, no? Couldn’t a newcomer build up trust over time by demonstrated performance? We don’t have a limited supply of trusted lawyers or economists, for example. So, I’m not sure why the advice on bonds must be so precious that the market works like a cartel.
But we are obviously in a crisis period. One wonders whether the future will see new companies entering the fray by promising more honest, truly objective valuations. Notwithstanding the complexity in evaluating the risk of innovative structured financial products, it seems to me that a few recently laid-off physicists and economists might come together to design better ratings formulas. Otherwise, we will undoubtedly see the same folks running the show. This may be fine in a world where classic corporate bonds predominate, but I’m not expecting structured finance to go the way of the dinosaur.
So we return to Rosenkranz’s proposal for market self-regulation. Can spreads on yields adequately measure risk?
One problem may be the potential for manipulation of the bond market — much like the way Soros and others moved currency markets in their favor. What will stop an investor from influencing the spread on a bond in such a way that tremendous pressures are placed on the holder to find capital quickly (not so easy in these illiquid times)? As long as this isn’t declared illegal, I suppose nothing is wrong. (No one accused L.T.C.M. of being unseemly.) But we could see such high volatility as trust becomes further eroded and lending becomes unpredictable and riskier.
I’ve never believed in the free market myth, but faced with the choice of letting the usual-suspect ratings agencies continue misfiring, I’m open to letting the markets rule themselves.