March 7, 2022

Poor Standards

This week we look into rating agencies and ask: Why were they invented? What is their purpose? Who pays their wages?

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This week we look into rating agencies and ask: Why were they invented? What is their purpose? Who pays their wages? (Repeat) Transcripts and more at


Will Page: Welcome to Bubble Trouble, conversations between the economist and author Will Page, that's me, and the independent analyst Richard Kramer that layout some inconvenient truths about how financial markets really work. Today, poor standards, how to spot theater when you see it, more of that in a moment. Last week's trouble forms this week's bubble. And remember, over the past five episodes, we've looked at the building blocks to raise awareness of bubbles and how to avoid them, the foundations if you like. If you haven't heard them, you'll enjoy going back to listen. Now it's time to keep on building. Welcome a long Richard.

Richard Kramer: Hey Will.

Will Page: So we're in real time here because last week we discussed going to SPACS and back, and that was great. What I didn't expect to happen between last week and this week is what I was presented with, which was a SPAC. I want you to follow me, Richard, because this puts a lot of what, the advice you gave our listeners into practice. So speaking to the SPAC with a great plan of transforming the business that it is in, and towards the end of the conversation they explained their headcount policy, which is they're going to hire all of these executives from Standard & Poor's. I didn't know who Standard & Poor's were and you will surely know who Standard & Poor's are after the next 30 minutes of conversation.

But I don't know who these guys were, but they're gonna hire these executives to dress the company up. Am like, "What do you mean?" "Oh, this is our ratings agency. And if we're going to have a SPAC, we're going to bring it to market, and we need to dress the company up so it's seen favorably by the market participants." I'm like, "What's going on? What's happening with this language of dressing a company? Why do you have to dress a company up? Was it not wearing any clothes in the first place? So I've decided to call this podcast Poor's Standards. I want to get into who Standard & Poor's are? Why were they invented? What is their purpose? Who pays their wages? How do they get promoted? Where do they go after they've worked there? I want to get into the Standard & Poor's, the Moody's, this whole waiting thing and just unpack it for the listeners so we can understand the role that we play in creating bubbles. And the consequences of those bubbles is how he saw often find ourselves getting into trouble. Richard, break it down for me, who are the rating agencies?

Richard Kramer: So Will, if you recall, one of our building blocks was talking about the sycophants and stenographers, the analysts who's as you aptly put it, whose job it was to praise, not appraise, who are there to say congratulations on a great quarter and ask a question with the preface, how should we think about, in other words, I'm an empty vessel fill me with what you want me to say. [Laughs] Now, in the case of Standard & Poor's, Moody's, and the other ratings agencies, they also have a fundamental conflict of interest. Their role is to examine all of the myriad elements of debt issuance when one company is seeking loans from investors or another company or other groups of companies. And they're the ones who examine the cashflow projections of the company, trying to borrow the money and suggests that indeed this package of assets is worth lending against.

Now, if you go back to the global financial crisis and the subprime crisis and so forth in the US, you'll remember that those agencies were at the heart of rating bonds or packages of mortgages as AAA, when they were indeed composed of less than AAA quality mortgages. And I'm just trying to keep it very simple here, but it calls to mind the old joke about sausage, and you never really want to ask what goes into it, you just hope that it tastes good.

Will Page: I have to say that applies to haggis as well.

Richard Kramer: I'm sure it does Will and I'm sure you've eaten many a bit of haggis in an inebriated state where you just didn't want to think about what you'd just bitten into.

Will Page: Deep fried, baby, deep fried.

Richard Kramer: So the point of the rating agencies is that they are paid by the issuers of debt. So the people that are trying to borrow money are paying the rating agencies to look over their projections. And obviously the rating agencies have every incentive to say favorable things, because guess what, if they constantly said unfavorable things they might not be asked to rate that debt anymore. I think this issue where paid business model is an inherent conflict of interest. And what you're talking about is that conflict of interest being taken one step further to actively mislead investors.

Will Page: It's getting murky already, and we're only four minutes in. But step back for a second, there was a world before the smartphone, there was a world before the mobile phone, there must have been a world before ratings agencies existed. So presumably on the eighth day, God did not create these things, where did they come from and how did it work before they existed?

Richard Kramer: I'm not a historian of the rating agencies, but in the same way, as you've celebrated and turned into a cult, this notion of the equity research or the securities analysts that somehow have the magic touch, you also built up a tremendous oligopoly of these rating agencies and it's Moody's, Standard & Poor's, and Fitch, and a few others that are really involved in nearly every element of debt issuance around the world in a multi trillions of dollars market. So I think in this case, you have a classic case of following the money. Who pays these people? They're paid by the issuers of the debt. And rating the stuff you're paid to rate, presto, you're likely to turn out positive.

And when there's only two or three of them, it ends up being somewhat of a cartel and the analyst knows that, hey, if we don't rate this well, you're gonna go to one of our short list of competitors and we wouldn't want to lose that business. Now there's a terrific analogy, when you look at the accounting firms and we talked in a previous podcast about some of the issues that arise from having the big four and each one of them somehow becoming mired in multiple scandals, who pays the accounting firms, the firms that have asked them to look over their books? And if they find something that's questionable, the decision is likely to go in favor of the folks who sign your paycheck.

Will Page: So you just said something there, which was there's two or three of them. And we'll go through the alphabet soup of acronyms in a minute. But you just said there's more than one. Now, if you have a regulator, that's typically a monopoly function, you only have one monopolies and mergers commission authority, or as I explained in my book, the famous screaming laws sucks from the monster rating... [inaudible 00:07:04] Lindy Polly asked, "How can you have only one Monopolies and Mergers Commission Authority?" You have to have two regulators to uphold competition. You can't just have one. You can't monopolize role of having competition, some linear logic there.

But you just said there's two or three. So I want to get this locked down in terms of the institutional lens. Like they're not regulators per se, but they are serving a regulatory function yet they compete with each other and they're compensated by the people issuing the debt. Walk me through how that works if I were to be expecting a rating agency to be a not-for-profit government regulated monopoly, public service duty, but then I suddenly flipped the lid and realized there are for profit private companies that compete. They're not institution.

Richard Kramer: No, they aren't. They are private profit making enterprises, they're stock market listed, so they need to deliver returns to their shareholders. They need to preserve their position, this oligopoly if you will, on debt issuance.

Will Page: So we actually have a rating of rating agencies? Do they rate each other as well as the companies?

Richard Kramer: If I suppose, if they would issue debt, they would have to get one of their competitors to write their debt.

Will Page: [inaudible 00:08:14] in comedy sketch already. [laughs]

Richard Kramer: It does, but there's no comedy. It turns quickly into a tragedy, when you realize again, in the global financial crisis, you had these rating agencies under tremendous pressure to give favorable ratings to a collection of debts, in this case, household mortgages, many of which were obtained under false pretenses, or simply weren't nearly as good as they were expected to be. But by mixing them all together with the good and the bad you could rate the whole debt instrument as good. And again, this came down to incentives, even the dumbest analyst at an integrated firm, which has conflicts of interest will understand where their bread is buttered and indeed what the risks to their career might be by turning around to a large debt issuer and saying, "You know what? I just don't believe your projections."

Will Page: Now in my book, Tarzan Economics, I explored the world of advertising. Whereas in the past you had a neutral church, a Switzerland of Yuan, and in this case, Nielsen who had measured audiences in price advertising and allow the market to function. Now you've got the Googles and Facebooks who don't use these neutral charities, these middleman, they just mark and price the advertising themselves. And that's where I kind of term mark your own homework. I'm just wondering, does that term, mark your own homework apply to this weird world of rating agencies?

Richard Kramer: It absolutely does. And it applies equally to the way in which investment banks often function in the market, because they're in the position of determining the price of an IPO for example. Obviously the larger the deal size, if they're getting a percentage of the fee of the deal, the greater the income for the bank will be. And yet so many of them managed to either soar or plunge on their first day because they've been mispriced, which suggests they don't really have a good handle on demand, or they're just doing favors to their best clients by pricing an, an IPO at a lower level than they think it will trade to and giving their clients the ability to sell on the IPO after the first day pop, so to speak.

And this sort of marking of one's own homework raises another issue that you and I spoke about in a previous episode, which was information asymmetry. If the bank or the syndicate that's bringing the debt or the IPO to market has a really good sense of what the depth of demand will be, then they have the ability to price it effectively. But if they're uncertain about demand, they might just wanna say glowing things which may or may not be true entirely and realize that they're going to get their fees, but they're not so concerned if an IPO plunges after it comes out or an issuer of debt defaults because hey, we put 18 or 30 pages in the prospectus about risk factors and didn't you see that one of them could've come through.

Will Page: So this has given me flashbacks here of one of my favorite films, and I'm sure many of our listeners will dig this movie too, which is The Big Shore. There is... The ratings game is touched on in that film, right?

Richard Kramer: Absolutely. And there's a terrific scene with the late Anthony Bordain explaining the subprime crisis using the analogy of fish stew. So he says, you're sitting there as a chef, getting ready for a Sunday evening in his restaurant. And he's got some fish that got delivered maybe on Wednesday or Thursday or even Friday. And maybe it's just not as fresh as it otherwise would be if you had to serve it alone on the plate. But hey presto, chop it up, cook it down in a fish stew and it tastes like all the other fish.

And that's precisely what happened in the subprime crisis. You packaged poor quality mortgages with good quality mortgages, sold them together in a package, in a single debt instrument as if they were all high quality mortgages. And in some cases you allowed the investors to choose which mortgages to put into the package and allow them to bet against it by betting that it would fail. So not only did you allow one of the customers of the restaurant to decide what fish would go in the stew, but you allow them to take out an insurance policy against bad reviews as well. [laughs] So when the rest of the customers got sick, because they ate this rotten fish stew, then that investor profited because they had an insurance policy against bad reviews.

Will Page: Anthony Bordain. That's great seen. And I don't think I read as many obituaries of anyone who's passed away as I did of Anthony Bordain. And the greatest quote or testimony to his life was his philosophy, which was, "Only by uncovering food can you discover a piece." Like you genuinely felt the unappreciation of people's dietary tastes of their food, of their economy practices could help establish peace in countries where there's currently military tangents, amazing individually.

Richard Kramer: And just by the way, there's another great analogy in the advertising world, which is if you're an advertiser and you've got to get reach, which means I need a billion impressions out there on the web for my new product. I wanna make sure that everyone hears about my brand new product. And I'm buying based on a CPM, which is a cost per a thousand impressions. And let's say I'm paying a dollar for a cost per a thousand impressions, but my budget is a $100,0000. So I'm buying a billion impressions. Can I actually go through and check that each one of those impressions was actually delivered and shown to a real person, that it wasn't seen by a bot, that it wasn't, uh, a one by one pixel on a smartphone, that it was actually viewable in the frame of where the user was watching? No, I can't check all that stuff.

And you have the same thing with packaging of mortgages or packaging of debt in that very few of the buyers of that debt can afford to go through painstakingly checking the quality of all that goes in there in the same way as you trust a chef and you don't ask, can I see each one of your ingredients and give it a little sniff test to see if it's fresh.

Will Page: So we'll take stop on this, warped world of ratings and come back and part two where we'll deliver some smoke signals so we can see them in practice. Back in a moment. You're back with Bubble Trouble, part two, as we explore Poor's Standards and get underneath these weird and wonderful rating agencies Standard & Poor's, Moody's, and many others. Now I started the whole podcast off of with this personal anecdote, very personal anecdote of just learning about a SPAC and learning about how the SPAC intended to hire executives from Standard & Poor's to advise it before it went for its IPO to dress the company up. And we explored SPACS last week, we came up with some beautiful metaphors, remember Richard. My favorite one and was a premature baby, which is lacking a business plan. What was yours again?

Richard Kramer: I said, give me money for an idea I haven't had yet. [laughs]

Will Page: And it helps if you're a celebrity 'cause you really believe that celebrities are gonna have a great idea, correct?

Richard Kramer: Mm-hmm [affirmative].

Will Page: Okay. So we have this weird SPACS and then we learned that SPACS are kind of in bed with the ratings agencies. What do you see the role of the rating agencies are in the current bubble of SPACS that we're seeing today? I mean, just, just join these two at the hip for me because they were there before SPACS, are they like having the party of a century now SPACS are in action because the fees are going to be so high?

Richard Kramer: No, this is just another bottle of booze play laid out on a [laughs] creaking table of drinks. Because the actual amount of money raised in SPACs is a tiny drop in the ocean compared with the equity or debt markets. So this is really, uh, a rounding error. Why anyone is surprised by seeing yet another scandal of conflict of interest in accounting firms, in rating agencies, or an investment banks is beyond me, because these seem to be such regular occurrences that one almost takes them as normal at this stage. And if you read a newspaper like the Financial Times, they go from looking at Wirecard to, which is a phenomenal scandal to looking at Green Cell Capital, another phenomenal scandal. And before that, they were looking at Karelian in the UK, just so much being uncovered.

Again, it comes back to this question of where are the regulators? Why have they been so supine? Why does in the words of this fantastic investigative journalist rag, I gave you a subscription to in the UK Private Eye, why do they call the UK financial regulator, the FCA, the Fundamentally Complicit Authority? [laughs] because they are simply not taking action in a principles-based regulation world to deter this wrongdoing. And the spoils, the opportunity to make money is too great and too alluring for all the market participants, for them to do anything that other than marking their own homework with an A-plus.

Will Page: Now you ask, where are they? A knee jerk reaction says they're on a nine to five tea break, or what's the expression from Adam Smith, "To trust the invisible hand of the market feels to see that the reason it's invisible is because it's not actually there." Um, one other potential response to that is you know, where are they?

Richard Kramer: Did Adam Smith really say that?

Will Page: [Laughs]. No, I said it. Adam Smith said thousands of words. He said the visible hand three times, three times his entire career. And not one occasion was it referring to free market capitalism. In fact, on two of those three occasions, it was warning against the dangers of free market capitalism, "Please, as an American, could you remind those free marketeers over in the states," that is the actual proper interpretation of what he said, not how it's being portrayed.

Richard Kramer: So the root and branch thing to trace out for you, the clever economist is who took that ball and ran with it? Who popularized that term in its misinterpretation?

Will Page: I would imagine it would be the Chicago Boys. The way I think about the term poacher and gamekeeper, surely we've got a beautiful example here of poachers and gatekeepers playing in, for the listeners, this is what I'm passionate about with this podcast. We will be getting ourselves into more bubbles and more troubles in the future, but you only have to look at the incentives. What is economics about? Is simply about incentives. People who work in rating agencies are human beings who want to get promoted, wanna get a pay rise, wanna get an added bonus, wanna maximize their own self wealth, just like anyone else, just like me or you. So if you're any good in a rating agency, you're not gonna stay around there for long because presumably your market value will be higher on the other side of the fence, right?

Richard Kramer: I think you're talking about if you're any good in a regulatory agency, as opposed to a ratings agency. I think those who work in rating agencies know that they have to toe the party line. And sometimes they have to look at sausage and just not ask too many questions about what went into its composition. So as long as there's no personal culpability on the part of executives, for them it's back to something else we discussed in another podcast called moral hazard. For those in the banking sector, they may regard breaking the law as just a business decision. The cost of compliance and paying a fine if you get caught is smaller than the opportunity cost of all the profits we can make by continuing to behave as we were, even if we know it's in contravention of the law.

And I think some of the points about the rating agencies that have been brought up and they've been investigated in the wake of the financial crisis and had new codes of conduct, but haven't really changed the behavior, is at the heart of this issuer-paid business model is a conflict of interest. And unless you do something to fund a public set of rating agencies that have a neutral business model and that every issuer of debt is obliged to pay to get their ratings, you're going to have a hard time getting neutral ratings.

Will Page: I gotta wheel back 'cause I got to beg your pardon for a second there. You're right and I'm wrong. I confuse rating agencies or regulators when I refer to poachers and gamekeepers. But by being wrong, I think it might also be right for this. So if I'm an incredibly good regulator, you really champion the public cause, impartial, um, immune and insulated from bribery and corruption, have done a great job, I will probably go from gamekeeper to poacher and get poached to work for the market.

Richard Kramer: Yep.

Will Page: So I got that wrong. That's the regulator. But if I'm an exceptional executive working for a rating agency, because it's a market-based model anyway, I don't need to go to the market side. But if I am that exceptional, it's probably not by doing a good job, it's probably by doing a really bad job because I'm being funded by the issuers of the debt, correct?

Richard Kramer: Whether you're doing a good job or a bad job assessing that debt you're being paid by the people you've assessed. So inherent in that business model. [laughs]

Will Page: But it gets close to the point of if you've been promoted at Standard & Poor's, you're probably doing a really good job at doing a really bad job, if you make sense of that. [laughs]

Richard Kramer: You're probably doing a very good job at mollifying the clients. And when there was a filing given to the SCC in the wake of the financial crisis, by an ex-senior executive of one of the rating agencies that said, "This conflict of interest permeates all levels of employment from entry-level analysts to the chairman and CEO of Moody's," that's another like Standard & Poor's debt rating agency. And he said that, "Moody's uses a longstanding culture of intimidation and harassment to persuade its analysts to ensure ratings match those wanted by the company's clients."

Will Page: All right, we got a few minutes left and I always like to bring into this podcast, smoke signals, just little clues that the listener can take forward. Once this podcast has done on our back to reading their blogs, their financial press, what can they hold onto from the podcast that will help them spot signals, smoke signals that the rating agencies are offering some poor standards?

Richard Kramer: The first smoke signal, and it pertains to many other areas we've talked about in other episodes, whether it's accountants or what goes on with investment banks, you have to assume and watch out for conflicts of interest. Who pays for the advice? Is it bought or is it freely given? And whether it's looking at Amazon or restaurant reviews, the industry analysts who are paid to assess products, it is inevitably likely to have some form of conflict of interest. For someone doing product reviews, they may receive that product for free. For someone doing a restaurant review, they may have got a free meal, or for the famous industry analyst in the tech industry, the gardeners and foresters and others in almost every case, they are being paid by the same companies whose products they're assessing. So I really cringe when I see the way people use the word independent because in very few cases, is it really properly applied?

Will Page: And a second smoke signal?.

Richard Kramer: You raised a fascinating one by bringing forward your SPAC example. And like our previous discussion around SPACs, you really need to play out the string and watch whose money you're taking and where it's going. The issue with SPACs is often that they involve a lot of dilution and the founders may be issuing themselves warrants and future rights over the profits of a company in any bankruptcy proceedings, that the key question is always who gets paid first when the assets are sold. So the other smoke signal to watch out for is who's getting paid? Who's getting paid now and who's supposed to get paid later? When you invest in something, a lot of times you're gonna have to wait for your returns, but if the Standard & Poor's executive that's working in this particular SPAC it's an upfront retainer, or it gets paid out of underwriting fees that are taken straight out of money that's raised by the SPAC, well, he's been paid today and you might get paid later.

Will Page: Well, I called this week's podcast Poor Standards because what I wanted to do is unpack Standard & Poor's business model, uh, to get to grips with the incentives that drives it. And to almost to have with good intentions, things can get a bit wharf. We do need our homework to be marked, the problem is who's marking it and who's paying for them to do that marking as well? I'm not saying that rating agencies are wrong per se, but it's just how the markets behave leads to this kind of wharf behavior, and wharf behavior is what gets us into Bubble Trouble, just the incentive structure behind these institutions, just really is gonna produce more bubbles and more troubles in the future. I want to thank my colleague, Richard Kramer. And remember this week's bubble is next week's trouble. I'm Will Page. If you're new to Bubble Trouble, we'd encourage you to follow the podcast wherever you listen. Bubble Trouble is produced by Eric [inaudible 00:26:03] and Jesse Baker at Magnificent Noise. You can learn more See you next time.