Tuesday, April 14, 2009

Letting the other team pay the umps 

We had an excellent presentation last night by Jouko Sipila '93, a double major in economics and finance who had worked in both reinsurance and finance on Wall Street and who managed to leave just before the worst of times last summer. His talk contained a series of slides on the nature of credit default swaps and CDOs. We got to see (and it was the first time someone had tried to seriously explain) a CDO^2, a CDO of CDOs. There were boxes and arrows flying all around the screen. "Do you find this confusing?" he asked. We all did. "So did we."

(BTW, there's a rather PG-13 rated slide show that made the rounds last fall to be found here.)

One of the places where I expect blame to be laid, complete with Barney Frank auto-da-fe, is the ratings agencies. Bloomburg's Caroline Baum, commenting on the failure thus far of the TALF program to jump-start credit markets, makes the point:
Most investors have neither the time nor the temperament to pick through individual loans that are pooled, sliced, diced and transformed into something with a credit rating and a cash flow to determine their viability. That job was designated to three credit-rating companies -- Moody�s Investors Service, Standard & Poor�s and Fitch -- which were paid by the issuer of the securities, not the investor.

That wasn�t always the case, according to Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. Prior to the 1970s, the onus was on the investor to pay for ratings.

That relationship removes the conflicts of interest inherent in the current system. Investors should be the one paying for credit evaluation, Kasriel says. �They�re getting a free ride.�

They also got what they paid for.
I wasn't aware of that history, and now want to know why we changed to having the issuer pay. Were investors just being cheap? Aren't they smart enough to understand the incentive incompatibility? It just seems very strange. It's like going to Yankee Stadium and letting the New York team hire the umpires because you don't want to pay for plane tickets for a third party arbiter.

I just did not see how ratings agencies were any more able to determine the quality of a CDO-squared than a relatively sophisticated investor.

Also, I learned from the talk that AIG's chief regulator is the New York State Insurance Department. Is there any reason to believe that they had particular knowledge to evaluate the riskiness of AIG's financial products division? I read this on that site by the state insurance commissioner, a Mr. Eric Dinallo.
The fear in 2000 was that if we regulated credit default swaps and required holding sufficient capital, the market would go where unregulated sellers could make more money. We forgot that the biggest competitive advantage of the US financial system has always been safety, security and transparency. If we destroy that perception, the long-term cost to our society is incalculable.
We're paying that cost now because rather than allowing the risky business to run offshore we decided we could rely on someone else to tell us where the risks are. It wasn't just investors outsourcing risk evaluation -- government did too.

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