Thursday, March 3, 2016

The Big Short aka Falling Short

Got around to watching The Big Short and vaguely recall having the same reservations I had towards the book.  On my old blog, I'm sure I'd done some commentary on the book or maybe that was back in business school, but the movie/book completely whiffed with regard to the role of ratings agencies in the 2008 crash.

There's a scene where Steve Carrell goes to Standard and Poors asking whether the agency actually examined the risk profile of the mortgages that made up the various instruments they were rating and the representative for S&P confesses that if they don't give the big banks the AAA ratings they ask for, the banks will just head down to Moody's (their chief competitor). Oh, it's just those evil Wall Street profiteers again! More regulations would solve things!*

But this explanation as to why S&P gave garbage assets AAA ratings was grossly incomplete. Imagine you started a business that gave safety ratings for food and you sold your findings to interested parties. Dining guides would be a prime market.

Dining guides would only buy your ratings if they were accurate. Now it is certainly possible and in many instances likely that an unhygienic restaurant would try to buy a higher rating than deserved. And you might even accept their bribe. But once people found out, your business would be ruined. The general incentive is to try to provide accurate ratings even if you were a super greedy unscrupulous businessman. It's the best way to stay profitable.

The overall goals of the company, of course, are not always shared by every employee. That is, commissions might entice reviewer employees to do a superficial inspection and accept bribes. Defects in compensation and management structure all impair the ability of a company to accomplish its goals and companies that have the best systems in place for eliminating those defects are the ones that will enjoy higher profits.

In the short term, it's possible to boost profits by giving dirty restaurants A+ hygiene ratings. If your company had given Chipotle or Jack in the Box an A+ during the food poisoning scandal time, not only would dining guides no longer purchase your ratings services but restaurants would have little incentive to pay for a discredited rating.

It would not be long before a competitor ratings service captured your marketshare.

So why did S&P and Moody's give top ratings to junk securities?

Because government regulations specifically mandated the use of ratings from those two companies.

Imagine if the government made a law saying that all food safety ratings must come from your company. Guidebooks are required to pay for your service and at that point, it doesn't matter if your ratings are bought and paid for; the fact that your business is relatively insulated from failure means that taking bribes is be more profitable even in the long term.

* And the movie more or less closes with the theme that regulations would have prevented the crisis. More outrageous is the quick glossing over the fact that the government, nominally the representative of the people, forced us to bail out and protect the big banks and ratings agencies. It's one thing to be scammed by a company, but to have a party come in and force you to continue to support that company claiming it is "for your own and the greater good" is lunacy. But that's what happened.

How it should have ended: the shorts get their money, all the companies that placed the bad bets would have lost enormous value and gone under, we would have eliminated the NRSRO regulations that let the ratings agencies get away with fraud, the companies that were prudent in lending and securitization and performed due diligence in risk assessment would be thriving today instead of being suffocated by the zaibatsu that we were constantly told "needed to be saved".

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