Ratings and Regulations

So the S&P has finally bitten the bullet and downgraded US federal debt to AA+ from its forever rating as AAA. While this signals that according to the S&P US Treasuries are no longer the least-risky investments, what surprises me is the reaction of the markets.

So far, since the rating change was announced after US market hours on Friday evening, only one stock exchange has traded – the one in Saudi Arabia, and that has lost about 5%. While it can be argued that it is an extension of severe drops in the markets elsewhere in the second half of last week, at least a part of the drop can be explained by the US debt downgrade. Now, when markets elsewhere open tomorrow after the weekend, we can expect a similar bloodbath, with the biggest drop to be expected in the US markets.

Now, the whole purpose of ratings was supposed to be a quick indicator to lenders about credit risk of lending to a particular entity, and help them with marking up their loan rates appropriately. It was basically outsourcing and centralization of the creditworthiness process, so that each lender need not do the whole due diligence himself. You can argue in favour of ratings as a logical extension of Division of Labour. If lending is akin to making shoes, you can think of rating agencies analogous to leather tanners, to save each shoe maker the job of tanning the leather himself.

However, over the course of time, there have been two consequences. The first was dealt with sufficiently during the global crisis of 2008. That it is the debt issuer who pays for the ratings. It clearly points out to an agency problem, especially when the “debt issuers” were dodgy SPVs set up to create CDOs. The second is about ratings being brought into the regulatory ambit. The biggest culprit, if I’ve done my homework right, in this regard was the much-acclaimed Basel II norms for capital requirements in banking, which tied up capital requirements to the ratings of the loans that the banks had given out. This had disastrous consequences with respect to the mortgage crisis, but I’ll not touch upon that here.

What this rating-based regulation has done is to take away the wisdom of crowds in pricing the debt issued by a particular issuer. Normally, the way stock and bond prices work is by way of wisdom of crowds, since they represent the aggregate information possessed by all market participants. Different participants have different assumptions, and at each instant (or tick), they all come together in the form of one “market clearing price”.

In the absence of ratings, the cost of debt would be decided by the markets, with (figuratively) each participant doing his own analysis on the issuer’s creditworthiness and then deciding upon an interest yield that he is willing to accept to lend out to this issuer. Now, however, with ratings linked to capital requirements, the equation completely changes. If the rating of the debt increases, for the same amount of capital, the cap on the amount the banker can lend to this particular issuer jumps. And that means he is willing to accept a lower yield on the debt itself (think about it in terms of leverage).

Whereas in the absence of ratings, the full information known to all market participants would go into the price of debt, the presence of ratings and their role in regulation prevents all this information flowing out to the market in terms of the price of debt. And thus the actual health of the issuer cannot be logically determined by its bond price alone – which is a measure that is continuously updated (every tick, as we say it). And that prevents free flow of information, which results in gross mispricing, and large losses when mistakes are discovered.

I don’t have anything against ratings per se. I think they are a good mechanism for a lay investor to get an estimate of ┬áthe credit risk of lending to a particular issuer. What has made ratings dangerous, though, is its link to banking regulation. The sooner that gets dismantled the better it is to prevent future crises.

The Swarovski Earrings

On Friday evening I tweeted:

Louis philippe best white shirt – rs X1
Swarovski crystal earrings – rs X2
Dinner at taj west end – rs X3
Proposal accepted – priceless

Now I must confess that there was a lie. Which I tried to mask by using variables for the various values. Of course, at the time of tweeting this, I didn’t know the value of X3; though I figured it out an hour later. The value of X1 is well known. The lie was in the X2 bit. The thing is I don’t know. Because the Swarovski crystal earrings weren’t bought; they were won.

Back in 2000 when I entered IIT Madras, I started doing extremely bad in quizzes there. It took me a long while to get adjusted to the format there (long questions, all-night quizzes… ) and a lot of stuff that got asked there was about stuff that I didn’t care much about so I didn’t really bother doing well. There’s this old joke that every IITM quiz should start and end with a Lord of the Rings (LOTR) question with two more LOTR questions in the middle, and all this is only in one half of the quiz.

In my first year there, there was also the additional problem of finding good people to quiz with. You invariably ended up going with someone either from your hostel or your class who might have attended their school trials for the Bournvita Quiz Contest, or sometimes quizzers you know from Bangalore. Still, the lack of a settled team meant that there was a cap on how well one could do. All through first year, I didn’t qualify in a single quiz, neither in Madras nor when I came home to Bangalore.

Second year was marginally different. There was still no settled team but the format wasn’t strange any more. And quizzes had started to get a little more general and less esoteric. I had started to qualify, or just miss qualification, in some quizzes. And around this time, while struggling with VLSI circuits and being accused by the Prof of being potential WTC Bombers (this was a few days after 9/11) I heard God and Ranga talk about some Dakshinachitra where they had qualified for the finals.

So Dakshinachitra is this heritage center on East Coast Road and they had been conducting an India Quiz. It was a strange format – three rounds of prelims with two teams (of two people) qualifying from each round. God and Ranga had gone for the first round of prelims and had sailed through. They had told me the competition hadn’t been too tough and so the following week Droopy and I headed out, taking some random local bus to the place.

We too made it peacefully to the finals and then found that it had turned out to be an all-IIT finals. However, they refused to shift the venue of the finals to the IIT campus and so all of us had to brave the Saturday afternoonMadras sun and head out again to the place. Thankfully this time they’d organized a bus from somewhere close to IIT.

I don’t remember too much of the finals apart from the fact that there was a buzzer round with extremely high stakes, in which Droopy and I did rather well. I remember one question in the buzzer round being cancelled because an audience member shouted out the answer. I remember there was this fraud-max specialist round where we were quizzed on a topic we’d picked beforehand. Thankfully the stakes there weren’t too high. It wasn’t a great quiz by general quizzing standards but what mattered was we won, marginally ahead of God and Ranga in a close finish.

The next morning Droopy and I appeard in the supplement pages of the New Indian Express, holding this huge winner’s certificate with Air India’s name on it (they took back that certificate as soon as the photo was taken). We were promised one return ticket each by Air India to any destination in some really limited list, but somehow they frauded on it and we could never fly. God and Ranga got a holiday each in some resort, and I don’t think they took that, too.

There were a lot of random things as prizes. There were some random old music CDs. Maybe some movie CDs too. I remember God and Ranga getting saris (god (not God, maybe God also) knows what they did with it). Droopy and I got coupons from VLCC. I put NED to encash them. Droopy went and was given a free haircut. And then there were these earrings.

Not knowing what to do with them, I just gave them to my mother. She, however, refused to wear them saying that since I’d won them, it was only appropriate that they go to my wife. So she put them away in the locker in my Jayanagar house and told me to take them out only when I had decided who I wanted to marry. And I, then a geeky 18-year old IITian, had decided to use these earrings while proposing marriage.

So early in the evening on Friday I went to the Jayanagar house and took the earrings out of the locker. What followed can be seen in the tweet. Oh, and now you might want to start following this blog.

PS: apologies for the extra-long post, but given the nature of the subject I suppose you can’t blame me for getting carried away