Tuesday, May 25, 2010

I'm Feeling Moody

Nice. Very nice. From Blue Matter:

Markets play a simple yet crucial role: they price (or 'rate') assets, so as to ensure societal resources are allocated efficiently.

Markets do this better than any other institution yet devised because people need to put their money where their mouth is; it is not enough to say 'I think Greece will default' - if you are going to have an influence on the price, you have to be willing to take the risk of losing money if your opinion turns out to be wrong, and you would only do that if you have confidence in your information and analysis. That way, the price of different assets, including sovereign debt, is determined by the people with the best information (or, as is the case when it comes to extremely deep and liquid markets such as sovereign debt, the best ability to process the information that is freely available to all).

So, it is a serious perversion of this basic principle when the credit ratings agencies spend 60,000 dollars a year (that's the annual wage of a junior analyst) on analyzing Greek debt while investing exactly $0 on it, yet the effect they have on the price of that debt is equivalent to their controlling billions in funds. What the hell does it mean to 'rate debt'? Isn't this what the market is supposed to be doing by setting the price?

I think there IS an answer to the question: the "skin" a ratings agency has in the game is its repuation. Underwriters' Laboratories, or Consumer Reports, can only survive if their ratings carry information. Information is a complex good, but if one person has information it is hard to sell without revealing the information. Imagine:

A: Is your advice on which blender to buy good?

B: Yes, I have excellent private information about blenders. I have tested hundreds of them.

A: Okay, prove it, before I buy.

B: All right, buy XXX and YYY, because of [reveals private information about blenders]

A: That's stupid! I'm not paying! [OR} Great info, thanks! I'm not paying!

Either way, not paying for a straight up transfer of information. So you get specialized firms, which can (a) charge subscriptions and (b) develop a reputation as a depreciable capital asset, a hostage against lying.

This only works because information about a blender, a car, or a movie, is not really very valuable. So a ratings agency can make sense by obtaining the information and selling it for a small price, like a subscription to CONSUMER REPORTS magazine, where they could never sell it piece rate.

But information on a bond? Or on the likelihood of default on Greek sovereign debt? Why would we think that a rating agency would tell us more than the price of the asset, in elite level financial markets? Good one, datacharmer!


Simon Spero said...

There are a number of cryptographic protocols that address this issue, under the generic name of "All Or Nothing Disclosure Of Secrets".

See e.g.:
Brassard, G., Crepeau, C., J, C. H., & Robert, J. (1987). All-or Nothing Disclosure of Secrets. Retrieved from http://citeseerx.ist.psu.edu/viewdoc/summary?doi=

Stern, J. P., Group, U. C., Maxwell, B., & Levant, P. D. (1998). A New and Efficient All-Or-Nothing Disclosure of Secrets Protocol, 1514, 357--371. Retrieved from http://citeseerx.ist.psu.edu/viewdoc/summary?doi=

Dirty Davey said...

The article is missing something here--the asset price is only fully informative if the market participants are completely indifferent to risk.

As soon as any degree of risk-aversion (or risk-taking) enters the model, the asset price (call it the "expected value") becomes insufficient information. What the ratings agencies attempt to do is to provide additional information about the distribution of results.

The market price gives you the mean, while the ratings agency is trying to figure out the variance. Not the same thing at all.