Nation of Beancounters

Where is the motive?

Posted in Uncategorized by Navin Kumar on October 8, 2011

Moody’s has downgraded UK banks, leading to another round of Rating Agency hate.

I find the hate against the agencies inexplicable now and I found them inexplicable back when they downgraded the US’s AAA status (causing the US government to act like a bunch of thugs).

Some of the arguments are spot on: the Big Three (S&P, Moody and Fitch) do have a monopoly and do control the fate of all people who subscribe. Yet it feels odd that this monopoly has never been questioned until the CRAs started interfering with the ability of governments to spend money. And just because they have a monopoly doesn’t mean they’re wrong.

The second argument is slightly more interesting: credit rating agencies have a poor record of predicting. But there are two kinds of errors here: high margin of error and bias.

High margins means that if the CRA announces that the probability of default is 10%, the actual likelihood is between 0-20% rather than 5-15%. But in such a case, the CRA will be right on average and you can’t know in advance if the rating is too high or too low. Thus maybe the US deserves the AAA rating. Maybe it deserves an A. There’s no cause for derision untill you can prove why the US or UK banks deserve a AAA. You have to demonstrate that your analysis is more sound.

The other argument is that it is systemically biased. This is the more standard argument against CRAs: in the issuer-pays model (where the company issuing bonds has to pay for the rating) a conflict of interest arises since these agencies have an incentive to give the bonds a higher rating than they deserve to keep the client happy.

But this implies that the CRAs give ratings that are biased upwards. Indeed, if this Huffington Post article is to be believed they make the same error with regards to sovereign debts: consistently giving too high ratings to companies. But this implies that that the current ratings are too high! So the US/UK banks deserve even less than they have! The haters have completely missed this.

For some reason, they seem to believe that giving too high a rating to subprime mortgages means that they’re giving too low a rating to sovereign debt. The disconnect is hidden be the use of the word “mistake” where they don’t specify the direction errors take.

Some people seem to genuinely believe that the CRAs are out to destroy the US or something. But where is the motive? The CRAs can’t have not known that they’d face political backlash, so their actions must have payoff that makes the backlash worth it. They are profit-making entities: they have no interest in Tea-Party-esque ideological posturing or the pursuit of some heroic ideal. They earn no profits from misreporting ratings. We wouldn’t convict a man for murder in the absence of a motive – but apparently the world of finance seems so removed from people’s comprehension that they’re willing to abandon basic judicial principles.

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