The Franken Amendment draws upon Richardson and White’s idea of a centralised clearing platform which I had criticised earlier. This proposal is based upon a flawed understanding of the structured products’ ratings process and the incentives guiding the agencies during this process and arises from a false extrapolation of the corporate and sovereign bond ratings process into the realm of structured products.
The fatal flaw in our ratings regime is not the issuer-pays model but the fact that ratings agencies only get paid if the bond is issued. In the structured products space, the difference between a potential AAA rating and a AA rating is not just that a higher spread is paid to the investor on the bond. The lower rating usually means that the bond will not be issued at all, which means that the ratings agency will not earn any fees. This problem cannot be solved even if we have a single monopolistic ratings agency paid by the SEC, so long as the fees are payable only upon issuance of the bond. As I have discussed earlier in more detail, ratings agencies are incentivised not only to expand market share but to expand the size of the market for rateable securities.
Let me explain the logic with a simple example. A pension fund approaches a bank for a bespoke AAA tranche on a portfolio of mortgage-backed securities. The bank constructs an appropriate tranche paying Libor + 100 bps and asks for a rating, upon which the clearing platform allocates it an agency. The agency comes back with a AA rating instead – so what does the bank do in this instance? It cannot change the tranching without damaging its own economics and the client will not accept a AA tranche paying the same coupon. So the deal just does not get done and the ratings agency is left without any fee for its opinion.
Let us go a little further along this chain of thought – all competing agencies are similarly stringent in their ratings and discover after six months that their earnings and dealflow have collapsed! At this point, they will of course gradually start easing their ratings requirements and sooner or later we will end up in the same position we were in before the crisis hit us. Its worth noting that this outcome does not change if someone other than the issuer pays the agency or even if we have a monopolistic ratings agency. Provided that the agency is a profit-maximising entity, the removal of direct competition may slow the process of easing of ratings criteria, but it will not change the end result.
In fact, the above example is too generous as it ignores the ease with which the centralised platform process can be gamed by banks. The central problem here is the fact that there are a multitude number of structured bonds that can fulfill a typical client request, such as the one above. For example, let us assume that the bank above constructs a tranche from a portfolio of MBS and applies to the platform which allocates it to Moody’s. If Moody’s comes back with an unsatisfactory rating, it cancels the issuance, makes a small modification to the portfolio and tranching and tries its luck again. The process can continue until the bank gets allocated to a more friendly ratings agency and the desired rating is achieved.
The fundamental issue here is that tinkering with the system in this manner is futile – the problems inherent in our current financial system are too fundamental and we have only two choices as I hinted at in an earlier post. We can either put in place blunt and almost certainly efficiency-reducing regulations or we can move towards a free-market system where the implicit and explicit protection provided to the banking sector is removed in a credible and time-consistent manner. To give you a simple example of a blunt regulation that will reduce the potential for ratings arbitrage, we could legislate that if a portfolio of sub investment-grade assets cannot be tranched to produce a AAA tranche. The price we pay for such regulations is that we eliminate a significant proportion of legitimate tranching, but this trade-off is unavoidable.