I was watching ‘The Big Short’ again and something stuck out to me. During the 2008 crisis, rating agencies were giving out AAA ratings to really bad investments. Have things really changed since then? What incentives do rating agencies have now? How do we know the same thing won’t happen again?
‘The Big Short’ movie kind of missed the bigger picture of what was happening during the 2008 financial crisis. The book was more focused on the trades these guys made. The movie tried to be more of a documentary but fell short on some key points.
For example, the movie shows rating agencies giving AAA ratings to bad debts like it was just carelessness or because they didn’t care. The reality was a lot more complex. They were using this thing called Gaussian Copula modeling, which seemed like a great way to measure risk at the time. It was used to diversify risk across different geographical areas, which worked… until it didn’t.
The problem was, this model worked so well that banks stopped worrying about individual mortgages and just focused on geographical diversity. When the housing market crashed across the whole country, the model broke down. Now, the rating agencies do take more care to ensure geographic diversity doesn’t overshadow credit quality. If you want to learn more about Copula, you can check out David Li’s paper on it here.
@Will
From what I remember, the Gaussian Copula was designed to work well for problems where risks were supposed to be independent, like in different geographic areas. The problem was, all these mortgage risks ended up being tied together. So, when one market crashed, they all did.
The modeling itself wasn’t necessarily wrong, but they were using the wrong assumptions. A fatter-tailed risk model might have helped, but they didn’t have much data to go on back then.
To answer the original question: no, the incentives for rating agencies haven’t changed that much. They still get paid to rate things, and if they’re wrong, there’s not much risk for them.
@Steele
Right, the real issue was how much faith they put in the geographic diversity assumption. It made everyone comfortable lending more and more, and the whole system overheated. Once it all started to crash, it became clear that the risks were much more connected than anyone had thought.
@Steele
At the end of the day, greed took over, and nobody bothered to check if the models still reflected reality. That’s where the regulators should have stepped in, but they were too focused on getting jobs with the banks. It wasn’t the fault of the models as much as it was the failure of regulation.
@Will
So, basically, they created a new risk by overusing a tool that was supposed to reduce risk? That’s an interesting way to look at it.
@Will
You’re using ‘revolutionary’ and ‘mispriced’ in the same sentence and still wondering why no Nobel prize was awarded? Sounds like a bubble to me.
Back then, they thought if you bundled enough bad loans together, you’d magically create something safe. They believed geographic diversity would protect them from widespread defaults. Of course, we know now that didn’t work.
Today, they supposedly use better parameters to grade these types of assets.
@Xian
It’s not ‘magic’—diversification is a sound idea. The problem is, all those bad mortgages were more connected than they thought. When everything went bad at once, the benefits of diversification disappeared.
@Xian
Great, they’ve got ‘better parameters’ now, but are the people working there any smarter? Has any regulation actually changed the way they operate, or is it still the same broken system?
@Xian
Dodd-Frank. That’s about it.
@Xian
Dodd-Frank did mandate more transparency from financial institutions. They now have to report all relevant trades to regulators, which gives a clearer picture of what’s going on. I worked on its implementation at a bank.
The Dodd-Frank Act was passed in 2010 to provide more oversight. They created new departments at the SEC and separated the sales and ratings departments in rating agencies. Now, investors can sue rating agencies for reckless ratings, though it’s still a gray area.
@Frances
Honestly, Dodd-Frank didn’t change anything that would have prevented the GFC. It’s mostly about creating guardrails for big institutions. Yes, the system is more transparent now, but it’s not stopping any major risks from building up again.
@Frances
So, basically, the smartest people are still in the private sector, making tons of money, while the regulators are always one step behind.
Ratings are just a way of telling you the likelihood of default. The ratings themselves weren’t wrong during the GFC. AAA and AA-rated securities didn’t default at a higher rate than expected. It was the lower-rated stuff that had huge defaults. The movie oversimplified what happened.
@Arden
Yes and no. The ratings weren’t completely off, but the geographic diversity that the models relied on broke down, leading to higher-than-expected defaults in lower-rated securities.
I used to work in structured products like CDOs and Mortgage-Backed Securities. These products are still around and still rated by the agencies, but some of the riskier stuff like CDO^2 is less common now. And at least there aren’t any NINJA loans anymore.
Honestly, nothing has changed.
Tobin said:
Honestly, nothing has changed.
I’m 33, and I remember learning about ‘black swan’ events in school. Do rating agencies account for those now?