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.

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  1. Cody says:

    First off, I agree with Gang Leader for a Day. Bought it. Read it. Loved it.

    And being libertarian, I agree with this article… Thanks Sudhir!

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  2. Imad Qureshi says:

    I disagree. This article ignores a lot of other facts on why these rating agencies are needed. Yes they failed in rating mortgage back securities but what about everything else they have done so far.

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  3. Hunter says:

    Fantastic idea! People rely way too much on uninformative indexes and telltales when making investment decisions.

    Now that we’ve abolished those particular anchoring heuristics, let’s move on to the DJIA, the S&P 500, the FTSE, the DAX… oh, wait, you mean people demand and pay good money for others to obscure and repackage data into easily-digestible but non-informative snack-nuggets?

    Well, it was a great theory anyway.

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  4. PsiCop says:

    I could be wrong, but I thought that Moody’s and the rest of the rating companies were, in fact, themselves products of the free market. After all, they did not just pop out of a vacuum, and they were not imposed on markets by government.

    The ratings companies evolved naturally, as private-enterprise solutions to the problem of assessing market risk. The rest of the markets trusted them, a trust that evolved over decades, and collectively looked to them for guidance.

    If the ratings companies — and the trust the markets had in them — were not products of the markets themselves, I don’t know what would have been. Can we be sure any subsequent solution the markets come up with, will prove to have been any more valid?

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  5. Mike B says:

    I never understood why such a critical market function was left in the hands of profit seeking individuals. Where profits are involved impartiality will simply fly out the window.

    Credit rating needs to reside within the domain of a Federal Agency or a Federally Chartered non-profit corporation. They don’t need a statutory monopoly like the Post Office, but for various regulatory requirements a sufficient rating from the impartial judge would be required. The fee schedule for being rated would be fixed and transparent and there would be a single transaction type, a debt issuer pays for a rating and they get a rating in return.

    The other possible solution would be to have NIST or whomever issue and maintain a set of standard rating guidelines and algorithms. These would be open to public inspection and competitive modification so that anybody with the required information and a personal computer could plug in their own numbers and get a NIST standard rating. In the Information Age, the information that once took rating’s agencies expertise to dig up and warehouse is often available to everyone at low cost. With a set pf open ratings criteria everyone with access to all available public information should be able to generate their own ratings. Ratings would be comparable across several sources and any discrepancies could be attributed to information asymmetries that could then be investigated by the market.

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  6. HM says:

    I have to agree with Psi corp. They are products of the free market in the credit space just as Morningstar is a product of the free market for equities. Being able to outsource analysis seems like free market capitalism to me..

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  7. mfw13 says:

    As anybody who has Dan Ariely’s “Predicitbly Irrational” knows, human beings are not particularly good at making judgemets regarding risk nor are they very rational.

    Free markets only work properly if participants have perfect information and make rational decisions. In the real world, however, people rarely have perfect information and are highly irrational, something which proponents of free markets tend to overlook.

    The ratings agencies aren’t great, but at least they give people more information than they would have otherwise.

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  8. Nosybear says:

    Lower than a garden snake? Garden snakes eat rats and mice, thereby serving a useful function. Even the venomous snakes perform vermin control, the very action the credit agencies no longer participate in.

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