Rating agency follies: money market funds edition

If anyone hasn't yet read Noah Millman's magnum opus on rating agencies and their pivotal role in creating our current economic crisis, then stop reading this right away and don't come back until you have.  It is one of the best explanations of how structured finance went awry and the rating agencies' role in the disaster.  As Millman notes:

The ratings agencies have an enormous amount of power: pension funds and insurance companies invest according to their rules; under Basel II, bank capital ratios are substantially determined by how the agencies rate their portfolios of loans; and, of course, the entire "shadow banking system" created by providers of super-senior credit protection (monoline insurers, bank-sponsored asset-backed conduits, AIG Financial Products, etc) was only possible because of the ratings agencies. By 2006, the entire financial system was extraordinarily leveraged to the opinions of these government-blessed non-governmental independent agencies...

Money market funds are another example of how deeply embedded the rating agencies are in the financial system.  Specifically, money market funds' portfolio investments are regulated - and quite heavily so - by Rule 2a-7 under the Investment Company Act of 1940.  The rule's details are forbidding (even to practitioners), but for purposes of this post, the rule defines "Eligible Security" in which a money market fund may invest as, in part, short-term debt securities that have one of the two highest ratings from a major rating agency.  The rule does stipulate that money market funds need to exercise independent judgment as to a security's credit quality and can't rely solely on a rating, but - aside from providing a previously useful heuristic - the ratings from rating agencies provide the background against which credit quality is determined, and the rule contemplates as much.  

You may have noticed that ratings on various forms of debt have been revised a few times over the last year and a half.  As such, money market funds have been in a similar position to many other financial institutions - figuring out how to deal with investments that were rated highly at the time but no longer.  Even before the Reserve Primary Fund "broke the buck" in the wake of Lehman's bankruptcy, the credit crisis had placed money market funds under unrelenting pressure to maintain the buck in the face of downgrades of their investments.  Many money market funds had substantial investments in "SIVs" and were vulnerable when that market collapsed in the fall of 2007.  Fund companies were able to provide enough support to their money market funds to avoid breaking the buck in those cases - an effort helped by the SEC working overtime to relax restrictions that would have limited fund companies' ability to lend such support (click here for an abbreviated list of examples).  

Now that the horse is several states away from the barn, the SEC has proposed to remove the references to rating agencies from the rule - to basically pretend that ratings don't exist.  Actually, its not clear what exactly this rule change is meant to accomplish; on the one hand, the SEC points out that funds were never permitted to rely solely on ratings - but on the other, if funds are still permitted to consider ratings in evaluating the credit quality of securities (which is what a rating is supposed to do) and are still required to restrict their investments to those with credit qualities equivalent to highly-rated securities, then why bother changing the rule?  And without the heuristic provided by a top rating, operating companies will likely find it that much harder to place their commercial paper with money market funds, which will only hurt the economy far beyond the financial sector.  Couple that with the fact that the rule change appears to put a fund's board in the role of evaluating investment quality (which is NOT their job), and it's no surprise that the rule change has provoked a firestorm of criticism and is probably not going to get adopted too soon (yes, I assume the risk of looking foolish if the amendment gets adopted shortly).  

But none of this means that the quality of ratings can be relied upon in the manner that prevailed prior to the credit crisis.  One of the best examples of how people thought about ratings can be found in n+1's "Interview with a Hedge Fund Manager" that occurred in January 2008:

HFM: Well, a paradigm shift in finance is maybe what we've gone through in the sub-prime market and the spillover that's had in a lot of other markets where there were really basic assumptions that people made that, you know what?, they were wrong.

The thing is that nobody has enough brain power to question every assumption, to think about every single facet of an investment. There are certain things you need to take for granted. And people would take for granted the idea that, "OK, something that Moody's rates triple-A must be money-good, so I'm going to worry about the other things I'm investing in, but when it comes time to say, 'Where am I going to put my cash?,' I'll just leave it in triple-A commercial paper, I don't have time to think about everything." It could be the case that, yeah, the power's going to fail in my office, and maybe the water supply is going to fail, and I should plan for that, but you only have so much brain power, so you think about what you think are the relevant factors, the factors that are likely to change. But often some of those assumptions that you make are wrong.

n+1: So the Moody's ratings were like the water running...

HFM: Exactly. Triple-A is triple-A. But there were people who made a ton of money in the sub-prime crisis because they looked at the collateral that underlay a lot of these CDOs [collateralized debt obligations] and commercial paper programs that were highly rated and they said, "Wait a second. What's underlying this are loans that have been made to people who really shouldn't own houses--they're not financially prepared to own houses. The underwriting standards are materially worse than they've been in previous years; the amount of construction that's going on in particular markets is just totally out of proportion with the sort of household formation that's going on; the rating agencies are kind of asleep at the switch, they're not changing their assumptions and therefore, OK, notwithstanding something may be rated triple-A, I can come up with what I think is a realistic scenario where those securities are impaired." And pricing on triple-A CDO paper was very, very rich. Spreads were very, very tight, and these guys said, "You know what? These assumptions that triple-A is money-good, or the assumptions that underlay Moody's ratings..."

n+1: Money-good?

HFM: In other words, if you buy a bond, you're going to get back your principle. It's money-good. You're going to get a hundred cents on the dollar back.

But in reality this was wrong, and people were able to short triple-A securities very cheaply. They weren't paying a lot to be short and they made huge money on triple-A securities and triple-A CDO paper that now trades at fifty cents on the dollar. I mean that is like the water's not running today, right? The sun didn't rise. But if you were trained in finance, you probably are more likely to take for granted that, "The rating agencies have a very sound process, credit analysis, the same process that I've been trained in, all the assumptions that I use are kind of the same as the assumptions they use."

Now, people know that ratings aren't something you can take for granted any longer, but nobody knows how to live without them.  Money market funds, for example, need the type of heuristics that ratings can provide in order to function in the pre-Reserve manner.  As Millman said:  

The market is inevitably focused on a short time horizon, fickle and volatile by its very nature. We want major financial institutions - banks, insurers, etc. - to look beyond the market to longer term risk metrics. Without the agencies as an independent arbiter of what these might be, the market is all we have left.

I don't know what the right answer is in terms of creating better rating agencies:  I think that the conflict of interest arising from the agencies getting paid by the issuers (which has attracted so much criticism)  is overblown as a causal explanation, if only because (as Millman also points out) if the rating agencies' fee depends on a deal getting done, their incentive will be to get the deal done regardless of whether the check comes from the deal's managers or investors.  And public agencies are just as susceptible to risk miscalculation, as we have seen in the current crisis.  But it is hard to see how the markets can recover until reliable ratings exist again.

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Dr. Manhattan

Dr. Manhattan is the pseudonym of a lawyer in New York City who represents, among others, clients in the investment management industry. He started blogging in early 2002, when the entire NYC-based blogosphere could gather in one room (which they often did). In between his frequent retirements, he blogged about politics, baseball, Israel and autism (especially vaccine-related matters) at blissfulknowledge.com. With the regulatory system up for grabs, for this project he has decided to try the novel approach of blogging about matters which bear some relationship to the topics that come up in his day job (within the strict limits of professional obligations, of course). In case anyone was wondering, none of his opinions expressed on this blog are necessarily those of his clients, employer or colleagues.

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