Forget about model-gaming, how about model-anointing?
December 20, 2012, 7:00 pm
Filed under: Uncategorized

I had intended to write a post endorsing (mostly) this mathbabe post coming at the issue of what went wrong (or not) with models in finance from the left, but I see Russ Roberts beat me to it.

I should note, though, as someone who has defended Brand Nate Silver™ in the context of his electoral-college simulation, that her post is sort of a revelation to people (like me) who had known nothing about actual Nate Silver. I had no idea, for example, that he had written something like this:

To suggest that Obama or Geithner are tools of Wall Street and are looking out for something other than the country’s best interest is freaking asinine. […] This is neither the time nor the place for mass movements — this is the time for expert opinion. Once the experts (and I’m not one of them) have reached some kind of a consensus about what the best course of action is (and they haven’t yet), then figure out who is impeding that action for political or other disingenuous reasons and tackle them — do whatever you can to remove them from the playing field.

Straight out of the Anakin Skywalker school of public policy:

ANAKIN SKYWALKER: We need a system where the politicians sit down and discuss the problem. Agree what’s in the best interests of all the people, and do it.

Turning back to mathbabe’s points, the one deficiency I see in her diagnosis of model-misuse is that it ignores the role of government. Everything is the fault of ‘a corrupt and criminally fraudulent financial system’. Which, okay. But what caused that? What enables it? There is no attempt to take a step back and view the larger picture. Or, perhaps one step back is taken, but you really need two.

Let’s take her example of AAA securitizations. I think the OWS/intelligent lefty critique of that particular model-misuse in finance goes something like this:

  1. Evil banks noticed they could game rating-agency models and stuff deals full of bad shit while still achieving a given rating, which would make them money for some reason let’s not get into or think too much about.
  2. When honest rating-agency employees cried foul, they were corrupted (“we’ll take our business and the big fees elsewhere if you don’t”, and/or “there’s a job in it for you on my desk next Jan if you play ball”) or steamrolled (“you’ll get fired if you don’t play ball”). So, for institutional reasons that we might look to fix/address/regulate away, bad risk was illegitimately stamped AAA.
  3. The banks made money and the deals turned sour.
  4. Because, banks are evil (see 1).

Again: okay. Fair enough. But don’t you need a step 0?

0. Once upon a time, for some reason, there were these big places called ‘Rating Agencies’, and whatever tiny string of letters they slapped onto an investment was somehow a really big deal, on which, oddly, billions of dollars could ride. Like, if a thing had ‘AAA’ stamped on it then certain folks would almost unthinkingly buy it.

But if you try to start this story at step 0, and if you actually think about it, it doesn’t work either, because you start to ask questions. Questions like, well, why? Because, that’s strange. And odd. And not natural. Nor some kind of organic free-market outcome.

And once you notice that and dig into why, almost inevitably, you end up with this answer: because of some government decision and/or policy back in the day. Seriously! Try it at home! I’ve found that it basically works every time. At least, I’ve encountered no exceptions.

So it’s true that people in finance gamed those ‘rating’ models and used them cynically, to try to maximize profit. Of course. But none of that would have mattered one iota if ‘Rating Agencies’ hadn’t been anointed the Official Government Arbiters Of Credit in the first place. It’s no different than a regulation declaring how big eggs have to be to be ‘Grade A’, or how much milk fat egg nog must have for you to be allowed to call it nog, and whether you can put turmeric in it. Yes, duh, no shit Sherlock, market actors will find the cheapest ways possible to meet your arbitrary rules and thresholds. It’s all well and good to get mad about this sort of model-gaming, but where is the outrage at the model-anointing that incentivizes it?

More to the point, we still make all the same mistakes when it comes to model-anointing. For example, see the “Basel III” style approach to capital.

But this boils down to your views on human nature, I suppose. One sort of view a person could take might be:

Government policy is a given. Government policy is there to do good. Government policy has decreed that it’s a good idea to officially and legally link capital-requirements, among other things, to rating-agency ratings. And so, that’s a given and we should not question it; it’s just the way things are, like the landscape. Now in an ideal world, it would all work perfectly because no one would ever game anything or respond to the incentives created by the policy; it would just work as intended. So that’s what we need to aim for. Only Greed prevented it from working. Therefore, what we need is to clamp down on and stamp out Greed, and disallow Greed from influencing the use of models. Then everything’ll be fine.

Call this the lefty/OWS view. But there’s another view which goes like:

Human nature is a given. One aspect of human nature is that people are Greedy. Another, closely linked, is that they respond to incentives. In context this means that if you set up a government rule which artificially adds value to a product based on some agency’s model-based ‘rating’, you can be sure that people will try to figure out the cheapest way to deliver a given ‘rating’. So, knowing this, how about let’s not do that maybe, or if we do, do it with open eyes and not whine about the predictable results afterward?

I would call this the conservative view. It is, of course, the view that I hold.

10 Comments so far
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Good stuff, and good analogy with the Ebert hypothetical from before.

Perhaps this is a silly question, but what is the alternative to that ratings structure? Say we phase out the ratings agencies as some sort of codified “This stuff is good; this stuff is bad” watchdog.

How do the less, dare I say-sophisticated, investors know what’s what? I see pension plans and retail investors having a lot more trouble. Even if AAA meant nothing because of everything we agree about above, at least there was some signpost.

Comment by tangentstyle

In Sonictopia, rating agencies could still exist, I’m not suggesting banning them or anything. The oldest have existed for 100+ years after all, starting out as magazine/journal type things. No reason that couldn’t continue; if investors found them useful & trusted their analysis, they’d use them; if not, not. Raters that gave bad advice would see their reputation suffer in the marketplace and lose business. There could be actual competition and incentives would be for quality, not quantity (imagine!)

What wouldn’t happen is that they wouldn’t be “NRSROs” because there would be no such concept. The issue with pensions/etc relying on AAA is more complex than them simply needing someone to tell them ‘good/bad’. The effect of ratings is deeper than that: they actually distort market prices themselves, because if something is “AAA” less capital is needed, it makes good collateral, it’ll be more liquid, you can easily repo, you ate levering up so spread is artificially low, tcetc. So when a pension fund manager buys AAA it’s not merely because it’s inherently ‘good’, it’s also that it has a degree of goodness that *comes merely from the rating itself*.

It’s not obvious why we’d want to distort the market in this way or keep this function. It’s one thing if these signposts are guiding investors down a path already there, quite another if they help *create* the path.

And of course, if we agree the signposts become utterly corrupted, that’s even worse. Of course whether you want to fix or remove the signpost is a matter of POV. Mine is clear.

Comment by Sonic Charmer

In the pension context, does the fact that a AAA asset counts as capital (so you need less other capital) a de facto issue or a regulation issue?

As I understand it, the other qualities of AAA assets (good collateral, liquid, easy repo) are just properties of high quality risk free assets.

What would be the problem with changing the “degree of goodness that comes merely from the rating itself”? I guess what I am asking is, why are there any special rules for AAA assets?

Comment by tangentstyle

The point is that those things are only ‘properties of high quality risk free assets’ to the extent that they are because of government codifying ratings into capital rules. In fact government is who has defined ‘risk free’ (in reality nothing is risk free of course, but government has declared sovereigns to be so, and AAA nearly so). It’s true that all else equal assets that were deemed to have low credit risk would have all those properties to *some* extent, my point is that the way ratings are used amplifies that effect.

As to your question ‘why are there any special rules for AAA assets’, I can only echo it as that is my question as well – there shouldn’t be.


Comment by Sonic Charmer

Thanks for answering my questions.

Comment by tangentstyle

That Nate Silver quote is astonishing. I think most lefties believe something like it, but I’ve never heard it put so baldly before. I mean, why have elections? Just appoint some experts and bask in the prosperity.

Comment by Matt

I considered that maybe he was being sarcastic, it veers on self parody…

Comment by Sonic Charmer

Change out ratings for standardized testing, and suddenly the left loses its shit. “Teachers just start teaching to the tests and no one learns anything!”

Note: I agree with the above, but unlike the left, also your point.

Comment by Mohammed Chang

I actually blog also and I’m authoring a little something similar to this posting, Blackout Shades
“Forget about model-gaming, how about model-anointing?
| Rhymes With Cars & Girls”. Do you mind if perhaps Iemploy a bit
of of your personal points? Thanks -Charmain

Comment by drusilla

Fine way of telling, and fastidious article to obtain information about my presentation focus, which i am going to convey in college.

Comment by Kirsten

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