Ten years after Lehman collapse few lessons have been heded

Rating agencies still wield huge influence and investment executives remain unaccountable

Arturo Cifuentes

A decade after the largest bankruptcy in American history, much remains to be explained and understood © Getty

Anniversaries call for reflections. And 10 years after the collapse of Lehman Brothers, the largest bankruptcy in American history, some inexplicable issues linger unresolved.

First, the survival of Moody’s and Standard & Poor’s (now known as S&P Global Ratings). The 2010 US Senate investigation was damning: both rating agencies, amid extensive conflicts of interests and using questionable models, gave triple A ratings to financial instruments that turned out to be houses of cards. Moreover, S&P admitted in 2015 as part of a settlement with the justice department (in which it paid $1.4bn), that its rating process was marred by irregularities.

Yet both companies remain the de facto regulators of the global bond market — they dictate what institutional investors can and cannot buy. Worse, their opinions affect interest rates.

Contrast this situation with that of Arthur Andersen, which surrendered its licence in 2002 after the Enron accounting scandal, an event smaller in size and importance compared with the billions of failed triple A assets. Last year, Moody’s reported an income of almost $2bn and Raymond McDaniel, its chief executive (a position he has kept since before the subprime crisis) received a total compensation of $11m. Clearly, he did better than Kenneth Lay, Enron’s former chief: Lay died in 2006 of a heart attack while awaiting sentencing after being found guilty of fraud.

Second, the chief investment officers of the institutions that bought the failed triple A assets have not received any criticism. Remember that these instruments were not sold to retail investors; they were only available for allegedly sophisticated players, who, presumably, knew what they were doing.

A case in point: the Abacus transaction, a mortgage-based collateralised debt obligation put together by Goldman Sachs in April 2007. By the end of that year, the $150m that IKB, a German investor, had put in the deal were wiped out. Goldman was vilified in the press, and it ended up paying $500m in fines to the Securities and Exchange Commission. On the other hand, nobody ever asked who the executives behind the German investment decision were.

It is worth remembering that the subprime bonds involved in the deal were fully disclosed (with their Committee on Uniform Security Identification Procedures) in the marketing material. And the ABX index, a subprime mortgage-based indicator, had lost one-third of its value between January and March of that year, which should have served as a warning before IKB wrote a cheque for $150m.

Did the IKB officials perform adequate due diligence? What about their fiduciary responsibility? These questions remain unanswered. We only know that while bankers lost the PR battle, most decision makers behind these triple A investment decisions remain unaccountable.

Third, the rationale behind the new insurance regulations is ill-founded. Solvency II, the insurance regulation initiative, was motivated by the collapse of AIG. However, AIG was an insurance company in name only. In reality, it was a highly leveraged speculative fund that ventured beyond the domain of traditional life and casualty companies.

The insurance sector survived the crisis fairly well. This is not to say that insurance regulation should not be improved. But Solvency II, which relies heavily on short-term volatility metrics, is unsuited to address the risks faced by insurance companies because they are not subjected to margin calls or bank-like runs; their potential problems are related to future liabilities that are easier to anticipate. Thus, their regulation should be based on assessing shortfalls, not short-term assets price variations.

Furthermore, one could argue that insurance companies are the natural holders of illiquid assets, but Solvency II, with its myopic risk view, will discourage these investments, and therefore will increase systemic risk by making insurance company portfolios less diversified.

Finally, the lack of mea culpa from the economics profession. Granted, many economists — Paul Krugman and Paul Romer are two notable examples — have acknowledged the shortcomings of most pre-crisis economics models. To be clear, nobody expects economic models to predict crises, future prices and recessions with total accuracy. But at least they should be able to explain the basic functioning of the economy.

The admission by Olivier Blanchard, in 2016, that incorporating the financial sector to macro models would be a good idea is revealing. (In essence, Mr Blanchard’s statement was akin to that of a structural engineer who realises that not incorporating gravity to its models might render them useless.) In any event, despite many exceptions, most tenured economics professors keep teaching the same simplistic, faith-based, empirically challenged models, combined with the belief that almost anything can be explained with a linear regression.

So 10 years after Lehman, much remains to be explained and understood. Coming up with better macroeconomic models is a long-term endeavour, fixing the current insurance regulation could take a few years and identifying the executives behind those unwise investment decisions made more than years ago is pointless.

But reforming the credit rating market is an urgent necessity. We can safely say that both S&P and Moody’s have proven to be solid triple A: they withstood the subprime crisis well. Shame on the regulators.

The author is an adjunct professor at Columbia University, finance and economics division, in New York and a research associate at Clapes UC in Santiago, Chile. He testified twice as an expert before the US Senate as a result of the subprime crisis.

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