resilience, not stability

Ratings Reform: The Franken Amendment and Structured Products

with 6 comments

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.

Bookmark and Share

Written by Ashwin Parameswaran

June 3rd, 2010 at 4:02 pm

6 Responses to 'Ratings Reform: The Franken Amendment and Structured Products'

Subscribe to comments with RSS or TrackBack to 'Ratings Reform: The Franken Amendment and Structured Products'.

  1. Do you have a post somewhere explaining how to credibly remove the public protection provided to the banking sector? I don’t see a way absent a constitutional amendment. Also, what do you mean by “in a time-consistent manner”?


    3 Jun 10 at 4:38 pm

  2. “Time consistency” is just academic jargon to say that the promise not to protect the banks must be credible. The regulator can always say that he will not intervene but when push comes to shove, he will be tempted to do so. In order to avoid this, he has to tie his own hands up in some manner.

    On how to remove the protection, that is the golden question and I don’t have a post on any solutions. Clearly deposit insurance needs to be removed but more importantly a significant proportion of debt in banks needs to be contingent capital, if not all debt. But the exact details of such a contingent capital system are tricky to figure out and more importantly, any transition needs some wholesale amendments to past contracts.


    3 Jun 10 at 4:52 pm

  3. My favored way of removing deposit protection is to raise FDIC premiums high enough that some banks begin to drop out of the FDIC. I would have the secondary impact that it would bail out the hole in the FDIC’s balance sheet.

    David Merkel

    3 Jun 10 at 10:17 pm

  4. David – That’s an idea I can definitely support! The harder part in my view is how we go about removing the implicit protection to other bank creditors post Lehman, and even more tricky is the moral hazard created by the Greenspan put variant of monetary policy which tries to bail out all asset prices in times of stress.


    4 Jun 10 at 12:59 am

  5. The issue you raise is a good one.

    Another strategy would be to ban securitization. That way, the person doing the credit analysis would also hold the credit risk. Ratings agencies don’t care if the are right or wrong — they get paid either way. The lender does not care if the loan will be paid back, so long as he can securitize the loan and get it off his book.

    In mortgage market, for example, there was no securitization in 1950s and yet, somehow, the US was able to produce plenty of houses for all, actually more than in recent boom I believe. So why bother with this at all?

    Deposit insurance is the one thing in the banking system that actually almost works correctly, and even it is badly implemented as it should be infinite. Removing it is terrible idea.


    4 Jun 10 at 5:24 pm

  6. […] He also points out the problems with credit rating agencies and structured products: […]

Leave a Reply