Saturday, October 31, 2009

Rating on the curve

The recent financial crisis represents a failure of the financial markets. As with other failures of complicated systems there were many contributing factors and many weaknesses were exposed.

One contributing factor was the failure of the major rating agencies to correctly assess the risk of collateralized debt obligations (CDOs) based on pools of residential mortgage loans. The resulting overly generous ratings allowed such CDOs to be sold for more than they were worth. This made assembling such CDOs extremely profitable and led to a flood of money into the residential mortgage market. The easy availability of mortgages in turn contributed to the housing bubble. When the housing bubble began to collapse it became apparent that many of the CDOs had been overrated triggering the crisis. Ironically one reason for the overly generous ratings was the failure of the rating agencies to properly consider the possibility of a housing bubble and subsequent price collapse.

Buyers have probably wised up to the risks of this particular product but the general problem still exists. Because the rating agencies are paid by the creators of the products they rate they have an incentive to give overly generous ratings. Similar grade inflation occurs in other contexts and can be difficult to prevent.

I am proposing a simple change that would alleviate this problem. The rating agencies should be required to rate on a curve. In other words instead (or in addition to) of giving a rating like AAA they would have to rank similar products from safest to riskiest. For example they could say a particular CDO was riskier than 36% of similar CDOs but safer than the remaining 64%.

This would have a number of positive effects. Like class rank this is a rating that is immune to grade inflation. It would encourage the sellers of the rated products to police the process as an overrated issue would knock down everyone else's rank. It would discourage the process of trying to produce products that just barely qualify for a target rating. And it would encourage potential buyers to look beyond a single letter grade.

No single change is likely to eliminate the possibility of future crises but the cumulative effect of a series of incremental improvements can be significant. This simple change would contribute.


  1. I do like the idea of the selling institutions policing themsselves to push sellers of bad investments into line. However, the market is driven by greed and fear, so investors may overlook the still small voice of reason and sellers the big punishing stick wielded by their colleagues.

  2. But I don't think that the primary cause of the crisis not a failure to discern which mortgage-backed securities were better than others, but rather a failure to see that ALL of them were way overvalued. Your suggestion does not seem to address the "systematic risk" of the prices of these things all being incorrect in the same directioon.

  3. My suggestion would have allowed prudent buyers to concentrate on securities in the upper part of the AAA rating class. If a substantial price gradient developed within the AAA class this would have been a warning sign that the AAA rating was being issued too generously.

  4. It is true the markets were oversold and that the prices were unrealistic helping fuel the crash, however it is probably not possible to find any method that will stop brokers from nudging the markets in directions beneficial to themselves not matter how we seek to police them.