Accounting for the Failures of Risk Assessment
Barth, Mary E.; Ormazabal Sánchez, Gaizka; Taylor, D.J.
Publisher: American Accounting Association
Original document: Asset Securitizations and Credit Risk
The practices of the world's three dominant rating agencies -- Standard & Poor's, Moody's and Fitch -- have remained little changed since 2008, despite the fact that they are, in the words of the Nobel prize-winning economist Joseph Stiglitz, one of the "key culprits" behind the formation of the subprime mortgage bubble, whose collapse shook the world's financial foundations.
Much has been said and written about the conflicts of interests that allegedly led agencies to overrate subprime mortgage-backed securities -- conflicts stemming from the fact that the companies being evaluated actually pay for the rating.
Other commentators argue that the perceived poor quality of the credit risk evaluations of rating agencies could also be the result of inadequate risk assessment procedures.
However, before digging into the potential causes of the problem, the claim that credit rating agencies underestimated securitization risks should be substantiated with rigorous empirical research.
A new study published in The Accounting Review provides such needed research. The study, written by Stanford's Mary E. Barth, IESE's Gaizka Ormazabal and Wharton's Daniel J. Taylor, raises serious questions about the way assets are accounted for, and the credit risk assessments done by credit rating agencies.
Different Ways of Assessing Risk
The authors probed evaluations of large bank holding companies, comparing the way risk was assessed by the bond market, on the one hand, and Standard & Poor's, on the other.
They found a significant difference between the methods used by the bond market to assess a securitizing firm's credit risk and the way S&P does it.
S&P ratings come in 21 gradations, from a high of AAA to a low of C. The bond market takes the difference between the annualized yield of bonds issued by banks and returns on one-month Treasury bills: greater spreads indicate greater risk.
The authors focused on banks because they are the largest group of asset securitizers. Furthermore, data on their securitizations are available from the Federal Reserve.
In a typical securitization, a firm legally transfers some of its assets -- whether residential mortgages, credit-card debt or some other type of receivable -- to a special purpose entity (SPE).
The SPE is a legal shell set up for the dual purpose of holding the assets for itself, generally the highest-risk portion, as an encouragement to investors.
In return, the SPE transfers to the securitizing firm an interest in the SPE, as well as cash that the SPE obtains from outside investors.
These transactions are called "securitizations" because, through these transactions, the SPE's investors obtain securities that prove their interest in the SPE, and hence, its assets.
They also serve as a means of diversifying risk among investors, who can have payoffs tailored to their needs and their degree of risk aversion.
During the process of pooling assets for securitization, a securitizing firm will normally retain a portion of those assets on its own books, signaling to potential investors that the assets are worth investing in.
A Difference of Degree
The major point of departure between bond markets and S&P's assessment of a securitizing firm's credit risk is the degree to which they evaluate the full spectrum of securitized assets.
Credit rating agencies perceive that credit risk is only associated with the firm's retained interest in the securitized assets, and not associated with the part that is now held by other investors.
However, the bond markets view both the retained and non-retained portions of the securitized assets as contributing to the bank's credit risk.
This finding adds weight to the allegation that "credit rating agencies were not diligent in assessing the effects of securitization."
Two Ways, Neither Clear
According to Barth, "It's not surprising that we encountered two markedly different ways of assessing risk, given the continuing disagreement among accountants as to whether asset securitizations most fundamentally are sales or collateralized borrowing."
In reality, securitization is neither a sale nor a borrowing, but something in between.
"Until the accounting is resolved, ambiguity will invite all manner of complex financial contrivances, which no amount of regulation is likely to counter very effectively. After all, how well can you regulate something when its nature eludes definition?"
Clearly, efforts need to be made to shore up the rating industry, and ensure that the conflicts of interest and misrepresentations that fuelled the subprime bubble are addressed, and fast.
One way of beginning this process would be to define what type of institution a rating agency is, the sort of relationship it should have with its clients, i.e., investors, and the extent to which its practices should be regulated.
"In the end, there are two principal ways to think about these agencies," said Barth.
"One is that they are as important as banks and insurance companies, and have to be as closely subject to regulation as those institutions are.
"The other is that agencies deserve to have the same freedom of speech as a broker who advises you to buy some particular stock -- but let the buyer beware.
"Either alternative could make sense, but right now, we have neither."