If there is one thing that has blighted the investment industry in the last two decades it is the increasing tendency to steer via the rear view mirror.

Before then, fund managers and bankers would take a considered view of what the future might hold. They would then allocate funds accordingly. Somehow this exercise of educated judgement came to be regarded as arrogant. Aided by the new ability to process vast amounts of information at high speed, outsiders were able to reveal that such judgments were frequently wrong and resulted in lost profits for investors.

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Setting themselves up as investment consultants, these outsiders began to run the show. Their financial models were able to show what had worked in the past. Woe betide any fund manager who dared attempt anything different. The problem, of course, is that what has worked well in the past does not necessarily work well in the future. The absurd belief that it will do so is one of the reasons for the credit crunch.

Post mortems and retrospective analysis of the crunch is now well under way. And now a valuable contribution has been made by the US Securities and Exchange Commission. The SEC has produced a report on the three credit rating agencies, Fitch, Moody’s and Standard & Poors. These played a central role in the huge growth of the market for residential mortgage-backed securities (‘RMBS’s) and the associated collateralized debt obligations (‘CDO’s). Their task was to provide a credit rating for these instruments on behalf of the big investment banks which constructed portfolios of them for sale to investors.

The calculation of a risk rating involves three things. First of all, portfolios of RMBs were constructed in such a way that investors could elect a certain level of risk. For example, they were split up into tranches so that investors could either choose to be first in line in the event of a default or further down the queue. This need not concern us here, but the other two factors should. One of these is the data that was input into the financial models of the rating agencies, and the second is the models themselves.

The data consisted of details of the various mortgage loans that were parcelled up by the investment banks. These mortgages came from ‘originators’ who were required to provide details of the mortgagees’ income, credit history etc.

‘At least one study’, says the SEC, ‘attributes the deterioration in loan performance to be due in large part to the deterioration in the lending standards of the originators,’ – probably including telling outright lies about the circumstances of the mortgage. The rating agencies, however, took the word of the originator on trust, whatever they might have suspected about loan quality, and worked on the assumption that the information was accurate. Now the SEC recommends that the rating agencies should disclose ‘whether and how information about verification performed on the assets underlying a structured product is relied on in determining credit ratings.’ In other words they must check their sources.

Putting rubbish into a financial model will generate rubbish

If you put rubbish into a financial model it will, of course, generate rubbish, and the more so if the model itself is faulty. But portfolios of mortgage-backed securities, the rating agencies assured us, were ‘stress tested’ using a financial model appropriately called the ‘Monte Carlo simulation of macroeconomic variables to create a loss distribution’.

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Clearly the range of assumptions was nothing like wide enough and, as the report says, this was because ratings agencies relied upon historical data, and so far as mortgage backed securities were concerned ‘the performance history that did exist occurred under very benign economic conditions.’

The report addresses two other areas of concern, the workload of the ratings agencies and the conflicts of interest that arise when the customer, in this case the investment bank, is keen to secure the best possible rating for the bundle of loans that it is trying to sell on. Although the report shows that the agencies at times failed to keep adequate records and had staff who were overworked and tended to cut corners, the agencies do not seem to have coped any worse than any other organisation experiencing a surging workload.

But there is evidence to support the charge of a conflict of interest. In a striking illustration one rating agency staff member, concerned with losing a client to a competitor, says in an email, ‘I had a discussion with the team leaders here and we think that the only way to compete is to have a paradigm shift in thinking, especially with the interest rate risk.’ Another says, ‘we are meeting this week to discuss adjusting criteria for rating CDOs of real estate assets because of the ongoing threat of losing deals.’

Competition for business between agencies that are supposed to be providing objective, analytically-based advice is potentially lethal and the report makes some excellent suggestions. One of these is that credit rating agencies should make public all their rating decisions and performance statistics for one, three and ten years so that we could then see which have the most conservative approach.

A new breed of raters of rating agencies?

A second is that the agencies are required to publish all their rating decisions, both of new instruments and revised ratings of old instruments. And a third, and potentially the most powerful of all, is that an agency should be prohibited from rating a structured product unless information on the characteristics of the underlying assets is made available. This would allow another agency to crunch the same set of data and judge whether the rating was fair or not.

In the financial world there are layer upon layer of people whose job is to look over the shoulder of others. I foresee a whole new breed of raters of rating agencies, which might just help to save us from a repeat of the credit crunch.

But a much greater contribution would be an acceptance that the rules of history are made to be broken. Too often investors are lured into mistakes because they simply extrapolate historic trends. It is time to allow some subjective, personal judgement back into the equation…

Regards,

Tom Bulford
for The Penny Sleuth

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