Pull back the curtain on Wall St.'s Wizards of Oz

The Wizard of Oz, filmed in 3-strip Technicolor

Image via Wikipedia

In an ideal world, the Securities and Exchange Commission would hold a daylong conference entitled: “How to Dismantle the Ratings Agencies and Restore Confidence in the Credit Markets.: Instead, on April 15 – tax day – the SEC will sponsor a “Roundtable to Examine Oversight of Credit Rating Agencies.” Go ahead, yawn. Or if you’re a taxpayer, go ahead and spit.

Despite displaying impressive incompetence during the subprime mortgage debacle, the rating agencies are essentially calling the shots on who shall live and who shall die during this crisis. Even the regulators appear afraid of their power. Last February, they paid visits on bent knee to beg the all-powerful Rating Wizards of Oz to give AIG a second chance on life: No more downgrades, please.

The agencies didn’t downgrade AIG but their cooperation cost US taxpayers in Kansas and across this great land another $30 billion. What we got for our money is unclear. (In a shocking moment of candor before Congress, Federal Reserve Bank Chairman Ben Bernanke rued that he didn’t have the power last September to put AIG, the too-big-to-fail behemoth, into conservatorship. Why that hasn’t happened since leaving the taxpayer so vulnerable is an open question.)

Warren Buffet calls financial engineered products weapons of mass destruction. The credit agencies wield much the same power without the mad scientists or supercharged bonuses. Thus AIG’s brethren in the insurance industry are struggling against the threat of nuclear downgrades; that’s probably one reason the government is likely to share the $100 billion or so still left in the $700 billion TARP pool with what were once viewed as dull, conservative corporations, the Wall Street Journal reports today.

What would happen if the rating agencies faded away or were simply de-fanged? In a recent New York Times OpEd piece, Jerome S. Fons, a consultant and former Moody’s managing director, and Frank Partnoy, a law professor at the University of San Diego, argue that the investment landscape would improve. In fact, they report the SEC “has called for eliminating reliance on ratings, but that proposal has stalled in the face of intense lobbying.” So much for the end of the lobbyist stranglehold proclaimed by President Obama.

But after all that has transpired, now is no time to give up: The rating agencies were instrumental in giving investors the dangerous illusion of safety. They were in fact clueless and when their judgment was most needed, it was lacking. Here’s how Fons and Partnoy envision a world without these false gods. The place to start is with the worshippers:

For their part, investors should stop putting ratings-related language into financial contracts. The terms of credit default swaps and other derivatives should be free of ratings-based triggers. Banking supervisors should insist that loan contracts not refer to ratings. Fund sponsors, pension plan administrators and insurance regulators should remove ratings-based criteria.

The financial markets can function without letter ratings. Instead of relying on arbitrary letters, regulators and investors should consider all of the information available about an investment, including market prices.

Finally, regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.

The return of judgment. That would be a great place to start building a New Wall Street.


7 thoughts on “Pull back the curtain on Wall St.'s Wizards of Oz

  1. The ratings agencies’ special role in the financial crisis has only just begun to be fully appreciated. Lloyd Blankfein’s speech yesterday begins to tell some of what happened, by pointing out how financial institutions outsourced — well, the critical thinking which is the basis for which they’re supposed to be compensated.

    But a couple of days ago I had lunch with, well, let’s just identify him as a former CEO of a company that has been much in the news over the past several months. He pointed out that when a ratings agency gives a AAA rating to an IBM bond that maybe should only rate AA, it’s not like IBM goes wild and issues an extra $20 billion. But when the ratings agencies gave a mortgage lender, or a particular MBS issued by Wall Street, a AAA rating even though it should only have gotten a single A rating, the mortgage lenders/MBS issuers knew just what to do: issue five times more securities than they would have at the higher appropriate rate.

    And of course the ratings agencies were compensated for every issuance. By giving subprime lenders the ability to access the market cheaper than they should have, the ratings agencies gave them a license to print money. Oh, and this part’s really sweet: the ratings agencies took a little slice each time the press printed. And thus we are in the mess we are in.

  2. Great post, I’m glad to see more focus being pointed at the credit rating agencies. I wonder if the ratings agencies would have done a better job if the business model was different? Can the agencies really be completely unbiased in their ratings if the debt underwriters are the one’s who pay the bill? The agencies certainly have a built-in bias to keep their clients happy. Could a different model work instead of completely eradicating the ratings agencies? Maybe some kind of investor-pays model similar to consumer reports?

  3. Unfortunately, we’ve seen this before…only in the guise of securities analysts for the investment banks who would provide positive research on a company just before the banking side would go forth and sell securities based on the research. And yes, the analysts would be bonused for their efforts. The good news is that this practice was largely cleaned up in the US (although not so much on the European stock markets). With the investment community now keenly aware of the failings of the credit ratings agencies, it is entirely possible their influence for decline for a number of years to come.

  4. Here is a letter I faxes to President Obama yesterday, you might find it pertinent.

    Lake Lugano

    9 April 2009

    Dear President Obama,

    As an American living in Europe you made very proud during the week you spent here. I have an “Obama” sweat shirt a friend gave to me, and when I wear it anywhere in the EU people try to buy it from me – or simply smile and nod.

    I wrote you a month ago suggesting you simply give the cash in the bail out funds to the people who would naturally distribute it to “where is will do most good” but I guess you never received the letter as I have no response – not even a robo signed copy!

    I think you might see clearly that whatever your people are suggesting to you is not working. I propose you read the Financial Times, 7 April 2009, and take a look at Prof. Nassim Taleb’s piece titled “Ten Principles for a Black Swan-proof World” – the title is wanting.

    The article is self-serving in some ways as Taleb has a book out with a similar name.
    However he makes a concise set of statements that should help you to examine the potential of taking a far different course before there is no other route to take.

    Taleb makes good points. I think you should take the following, which are based on his, to your next cabinet meeting:

    If something gets too big to fail it should not exist and will not in the long run.

    Privatized savings and Socialized rescuing do not mix. That means nationalization, at least for a time. Then a split up, and then a private sale.

    The people who ran things at the Fed, on Wall Street, in The City in London, etc, should never be allowed to participate in banking and brokerages again, not ever. There is no respect for them anywhere, and won’t be.

    Never allow people’s lives and motives to be managed by enticement. As Taleb says more poetically “Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”.

    Financial products must be simple and easy to understand – never complex. Complexity in this arena is almost always a cover-up. Keep it simple. Ban all complex derivatives and anything else your own eldest daughter can’t understand.

    Rehabilitate the financial system – do not even attempt, any longer to use leverage to cure leverage. It can never work. That is what you are doing now, thanks to well intended but bad advice from eager young people.

    Don’t worry about America’s confidence in you, or our system. You can’t afford to do that. In the end, we will see if you were right or wrong, but don’t violate these “rules” while you await the verdict. Don’t worry about what “we” think – most of us can’t.

    Don’t allow our retirement system to be monetized and “invested’. All citizens, especially those who are about to retire should not and cannot count on “markets”. As you’ve seen there is no certainty in them – and never has there been even a scintilla of safety in this system. Whatever safety there appeared to be – was a ruse.

    Get rid of your economists. They have absolutely no sense, and have never been correct in the long run, or the short in most cases. My son could do as well. Your and the First Lady’s youngest daughter could throw darts at the Dow and make or lose as much money in the “market” by so choosing stocks this way as any so-called “broker” or worse, expert.

    Our western economic system must be re-designed from the bottom up – not piecemeal. Capitalism is fine, but not capitalism run by unchecked and unsupervised greed. Our watchdogs should probably distrust the rich – even loathe them, not worship them. They would make better keepers of the flame.

    Also, remember this well – Make sure you understand and project a value system based on “How Much is Too Much?”

    Let the weak companies pass on. You can’t save them anyway. And while I will mourn the loss of GM, Ford, or Chrysler – I will be happy to buy whatever cars come out of that unexpected defeat. They will be the best cars ever. You started well, by getting rid of GM’s CEO, but then you replaced him with someone as unprepared as he. Not your responsibility. Just remember, it will not work. He does not have the right stuff to do the job – even to bring the company bankrupt without severe social unrest. There is not enough time or money to put Humpty Dumpty together again or find a new Humpty Dumpty.

    Take a very good look at airlines. They are coming at you next. They are largely run by pretty silly people because of a tradition in that arena. Tradition does not produce huge companies that work. Ship cleaners do not CEOs make.

    In short, Mr. President, you must get rid of the poseurs and the crooks, and all the would-be robbers now in the snake oil business schools that produce them – and that includes the Ivy League. Mostly our system is a victim of the worst kinds of fraud and malfeasance taught as a sideline unconsciously in these halls. However, ravenousness is a big part of human nature. And my God, human nature cannot be relied upon to be “good” when it comes to money or beauty.


    Mr. President, I spent 25 years in Washington, as a lobbyist, then an activist. Believe me; I know what you are battling. You are up against some my best friends. They can be quite tough and very shrewd. So must you be – but with a conscience that they will never be able to find again.

    You will win in the end, because you are doing the right things.

    Your proud expatriate supporter,

    Jeff Koopersmith



  5. What is a viable alternative to having an external option from some sort of rating agency? Maybe the issue is the fact that the agencies were too close to the issuers. It is the buyers who should be paying for the opinions if the buyers want to depend on the quality of the work. At the same time having a rating and having that rating adjusted over time does improve the market pricing compared to each buyer or seller needing to hire their own expert to offer an opinion.

    Ratings should not be used as a predictor of the future. They are at best a snapshot opinion. It should be from someone qualified to offer an opinion.

    We can blame the agencies. That is the easy part. Finding a better solution is less clear. Rating agencies evolved over time and have been around for some time. Throwing them out is not going to fix the problem. To fix the problem real alternatives would have to be considered including keeping the agencies but changing how they earn their fees.

  6. The credit agency system is basically corrupt and too much of the financial system relies on the final word of its analysts. Today, the Wall Street Journal reported that Fitch downgraded $36.6 billion of collateralized debt obligations. What good does that do anyone? Is there a single human being on Wall Street who isn’t aware that there’s a problem in the CDO market? The agencies are always a day late and a dollar short on their so-called outlooks. Worse, when things are bad, they make them worse. If the agencies are writing what one commenter calls only a snapshot, why do so many investors rely on their snapshots for long-term investments? It may be possible to re-structure the major rating agencies, but it would probably be easier to start over.

  7. The problem, as far as I can understand it with my limited understanding is that rather than explicit complicity being the reason why ratings agencies so amply failed to note teetering firms, these agencies fell afoul of one of the ironies of the market place. When political and financial leaders basically said that the crisis was not a liquidity crisis, but a confidence crisis, they were right. The nature of credit default swaps was such that institutions were solid, credit-wise, but suffered from the panicked reactions of third parties who lost confidence, were feeling their own external pull, or who had an active interest in triggering a cascading failure in order to short one or another company.

    The credit default swaps were like a gun in each hand, pointed at a different person’s head.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s