Wednesday, June 2, 2010

Phil, Meet Steve. Steve, Meet Phil

Former California Treasurer Phil Angelides began today's hearings of the Financial Crisis Inquiry Commission with the following analogy in his prepared statement:
Imagine if you had a laboratory that tested the safety of toasters. At first, a few toasters caught
fire. There would be an outcry about the toaster inspectors. And yet instead of halting the
assembly line you sped up production of these combustible toasters. After awhile, if you found
that 90 percent of the toasters that you rated as safe had caught fire you’d think that something
was fundamentally wrong.
Phil Angelides needs to meet Steve Coley.  Steve has the distinction of serving on the board of directors of Flagstone Reinsurance, and the board of trustees of Underwriters Laboratories.  The relationship between these organizations may not be obvious, but Angelides needs to understand it. [Full disclosure: I worked with Steve at McKinsey and on the board of Flagstone.]

As I wrote in my previous post, credit rating agencies make assumptions about catastrophic events, much like reinsurance underwriters.  Identifying skill based on outcomes poses significant difficulties.  Did a truly remote event cause the loss (in the financial markets or property markets?)  Did the underwriter have good luck and low skill?  Bad luck and high skill?

Toasters benefit from careful design and controlled manufacturing.  Evaluating results follows naturally.  Underwriters Laboratories literally wrote the book on this process.  UL can test every component of a toaster under controlled situations.  They very likely (I have not purchased UL 1026, I'm just speculating!) tell you that if these 613 conditions are met, the miraculous result is that the toaster will not start a fire 99.99% of the time.  That's a toaster, not an economy.

The first problem I see, is that Moody's and others would neither disclose all conditions, nor would they disclose their probability of failure. 

What's equally  troubling is that Angelides seems to indicate, according to the Wall Street Journal, that he understood the conflicts apparent in ratings agencies, yet he still chose to endorse their use as a seller of bonds (as California's treasurer) and a buyer (California pension plans.)   At least Warren Buffett, the largest Moody's shareholder, regularly explains that he didn't rely on their ratings.

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