Who Watches the Credit-Rating Agencies
Felix Salmon has a pretty interesting post about Berkshire Hathaway losing its AAA debt rating. This reminded me that the rating of one’s bonds by the bond-rating agencies is still really important. And also that the rating is done by the same people who were doing the rating two years ago. And that, I think, is a fairly huge problem.
One of the bolder libertarian contentions out there is that the world could do without the function that’s performed by the Consumer Products Safety Commission. After all, the logic goes, consumers want to buy safe goods. This means that producers want to be able to credibly signal the safety of their goods. That means that there ought to be, in a CPSC-free world, a market opportunity for a firms that rate the safety of consumer products. Toaster makers would hire toaster-inspectors, and ask them to give the toasters a clean bill of health. “That’s crazy,” you might say, “who would trust a toaster-rater who was getting paid by the toaster-makers?” But the answer is clear. A toaster-rating agency needs to have a strong, credible brand to be valuable to toaster-makers. Getting a seal of approval from a toaster-rating agency that’s known to cook the books in exchange for business would be worthless. So toaster-raters should stay honest, and those who aren’t honest should find themselves out of business.
Now as it happens, we don’t handle consumer product safety like that. But we do handle bond rating that way. But there are only three ratings agencies. And as it happens, during the late boom years all three acted corruptly. So instead of losing credibility and going out of business, all three are still in business. And when you think about it, something similar happened with the big accounting firms during the Enron bust.
It seems like a big problem to me. Perhaps part of the answer is a Financial Products Safety Commission as proposed by Dick Durbin (co-sponsored by Ted Kennedy and Chuck Schumer, borrowing an idea from Elizabeth Warren). But honestly, I like the free market approach here. I like the idea of a marketplace with multiple raters rather than a single regulatory agency—just think what kind of nonsense a Bush-era FPSC would have green lighted. Not that an FPSC is a bad idea, but I think it’s smart to have a rich, multifaceted approach to assessing these things. Except the market approach seems to have totally failed. Not just failed once in that the ratings-agencies screwed up. But failed in a fundamental way—the agencies’ screwups aren’t doing them any harm, and aren’t allowing any new firms to enter into that space. I don’t know the territory well enough to know in detail what’s gone wrong, but it’s obvious that something’s gone wrong. And it seems to have something to do with the fact that there are such a small number of players in both the ratings and accounting games.
54 Responses to “Who Watches the Credit-Rating Agencies”
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March 14th, 2009 at 10:36 am
urghh. I want to agree with this point but then there is this…
“when you think about it, something similar happened with the big accounting firms during the Enron bust.”
No. Arthur Andersen spectacularly dissolved because of its involvement in that scandal. Destroying a long venerable firm and terrifying the other accountancy firms.
Matt’s writing on business (in particular) has got really embarrassing in the last year. I hate to say it but it seems like CAP is cocooning him and making his thinking and writing lazier.
March 14th, 2009 at 10:38 am
who would trust a toaster-rater who was getting paid by the toaster-makers?
I don’t particularly trust them, but there really is privately-run toaster rating agency. You’ll find their seal on the bottom of your toaster.
March 14th, 2009 at 10:42 am
“It seems like a big problem to me. ”
me too!
i’m pretty sure that the answer is either
1) more libertarianism!
or
2) more guns! if only those school-kids had been packing!
or probably
3) more guns and more libertarianism!
March 14th, 2009 at 10:46 am
Even if we stipulate that, over the long term, it is in a private bond-rating (or food safety, or whatever) firm’s interest to have a reputation for honesty and independence, there will be constant opportunities for short-term profits in kowtowing to the clients’ whose products they are rating.
I trust the ratio of short-term to long-term thinking among American corporations doesn’t need to be dwelt on here.
In addition, there isn’t a certainty that selling out while reviewing a particular product will harm a rating firm’s reputation and value. It’s a risk that a particular product, given a high score, will then be subject to a recall or start setting homes on fire or whatever. So, to the management of the ratings agency, there is the certainty of profit weighed against what will be, in each individual case, a remote chance of something going wrong. Now, over the long-term, a whole bunch of those remote chances will add up to a high probability, but then, that brings us back to American corporations and their long-term thinking skills.
March 14th, 2009 at 10:50 am
there are only three ratings agencies.
Actually, there are 10. Other firms are seizing the opportunity to compete with the big 3. Of course, they may not succeed.
March 14th, 2009 at 10:53 am
I though we already had a Financial Products Safety Commission, and its name was the SEC. Having yet another tiger watching over these villains won’t do much good if that tiger—like the SEC–has no teeth.
March 14th, 2009 at 10:58 am
I like the idea of a marketplace with multiple raters rather than a single regulatory agency…
Ooh, cool! Maybe we could make it like eBay or Amazon. Investors could post their own reviews! “Although the Berkshire-Hathaway Optimus Prime Fund functioned adequately for the first six months I owned it, one day it abruptly began to emit a strange buzzing noise and thick clouds of black smoke. i have attempted multiple times to contact the seller to have the fund replaced, but my e-mails have gone unanswered. One star. Would not buy from this seller again.”
March 14th, 2009 at 10:59 am
Well, well, well…Welcome to the party Matt.
Large banks across the country are losing their credit rating because of mark-to-market…and we’re all for transparency as it drives the economy into the ground.
Then the sage of Omaha loses his credit rating and suddenly this is, “And that, I think, is a fairly huge problem.”
How much money has Buffett passed onto ThinkProgress?
This is simply ridiculous. So much for honest reporting/blogging.
March 14th, 2009 at 11:04 am
When Matt says “something similar happened with the big accounting firms during the Enron bust”, he must mean, except for AA going out of business, it was real similar.
March 14th, 2009 at 11:04 am
The trouble with the free market solution to faulty toasters (or tainted peanut butter)is the lag between the harm and the knowledge of harm.
A toaster may not toast well or it may blow your houses fuses, or kill you. That happens a few times and no one will buy those toasters. But given the ability of a large corporation to employ PR to spin and lawyers to threaten lawsuits for defamation (which can bankrupt you even if you are right), by the time that the message gets around quite a few people can be harmed, some seriously before the “invisible hand” clamps down.
The peanut butter fiasco is a good example. If I remember aright, 8 people died before there was any reaction. Are those 8 people to be regarded as casualties in the battle for the free market?
I am ever reminded of a passage in The Brothers K. where Ivan describes the stoning death of a child (who killed one of the master’s favorite dogs); he asks in effect (I don’t have a text handy) “If you could redeem the whole human race by sacrificing an innocent child, would you do it?”
And we’re not talking about redeeming the human race, but “redeeming” an abstract concept that is supposed to be the best way of creating wealth. As if that is the summum bonum of human existence.
March 14th, 2009 at 11:07 am
“But there are only three ratings agencies.”
No, there are ten rating agencies (recognized by the SEC).
[T]he agencies’ screwups aren’t doing them any harm, and aren’t allowing any new firms to enter into that space.”
Except for the 7 additional rating agencies the SEC has recognized since 2003.
Maybe you should stop writing about finance. You clearly have no clue what you’re talking about, and it’s getting really embarrassing.
March 14th, 2009 at 11:10 am
Man, here’s the thing that drives me nuts about all this “the market will decide.” When the libertarian/economist says, “Unreliable toaster-rater will be driven from the market,” the newspapers say, “Five people electrocuted by shitty toasters.” They just love how all this shit will just sort itself out automagically by the power of the free market and don’t give a rat’s ass about the human cost.
March 14th, 2009 at 11:16 am
Cry me a river, Ed.
Large banks across the country are losing their credit rating because of mark-to-market
Yeah, that’s it, mark-to-market killed those banks. It’s just an accounting trick. The American banking sector is actually in tip-top shape; it’s just that nasty mark-to-market rule creating the false impression that they’re in trouble.
March 14th, 2009 at 11:18 am
Arthur Andersen spectacularly dissolved because of its involvement in that scandal. Destroying a long venerable firm and terrifying the other accountancy firms.
Right, but the Final Four accounting firms all were also involved in pretty big scandals (Deloitte with Adelphia, KPMG with Xerox, PwC with a bunch of companies from 97-01 and Tyco recently, Ernst & Young with Cendant, OneTel, and AOL, and there’s more) and they survived, because it wasn’t feasible to whack them all. So it’s not clear that this process actually resulted in better accounting.
March 14th, 2009 at 11:22 am
I’m pretty sure that what’s needed are agencies that rate the rating agencies, allowing us to set up a market in rating reputation.
March 14th, 2009 at 11:30 am
But honestly, I like the free market approach here. I like the idea of a marketplace with multiple raters rather than a single regulatory agency—just think what kind of nonsense a Bush-era FPSC would have green lighted. Not that an FPSC is a bad idea, but I think it’s smart to have a rich, multifaceted approach to assessing these things. Except the market approach seems to have totally failed.
What Joe said, but in particular, what are the incentives? If a ratings company were paid by the people buying the products, what would happen if they got it wrong? Nothing. They can’t get sued for issuing bum ratings. Ratings don’t mean anything other than ‘your butt smells good at the moment’.
They other problem here is that at the time they were issuing these ratings, those ratings were correct. CDOs were, briefly, AAA. And they behaved like AAA. ‘Til they stopped. The ratings companies are bahaving like the prediction markets: lagging indicators of the conventional wisdom that give investors a security blanket they can hang on to when they lose all their money. ‘{sniff} {sniff} But they said it was wwwwAAAhhhhhhhhhhhhh.’
They’re the glade plugins in the restaurant of Wall Street that covers up the dead rodent smell! They damage they do is not by mis-rating a single thing, it’s by making people believe they can stay in a lot longer than they actually can.
Since they are peddling fraud, you probably should just get rid of them. Either that, or make them liable.
max
['They will protest that they are neccessary, of course.']
March 14th, 2009 at 11:34 am
Pssst, I’ve got news for you. There is no such thing as perfect protection. You’ve been watching to much TV. It takes a while for information to be gathered, correlated and acted upon, during which time there may be casualties. Don’t like it? Too bad. That’s reality.
As for the rating agencies, being supported by the organizations being rated is a corrupt process, and yes, the SEC was asleep at the switch. Personally I think class action suits for grand malfeasance should be initiated for the big three ratings agencies, and put them out of business.
On the other hand, the failure of regulation is the overarching reason for our current mess. Adding more regulation, especially politically based regulation, will likely hurt more than it helps.
March 14th, 2009 at 11:36 am
What is being ignored is that the government helped to set up the current cartel of bond-rating agencies and to shield them somewhat from competition, as mentioned here.
A return to the pre-1970s model of subscription service would likely ameliorate a lot of these problems, as admitted in this article.
March 14th, 2009 at 11:36 am
Presumably product liability lawsuits play a role in keeping product manufacturers and product rating agencies honest. Can I sue Moody’s for rating some junk as AAA?
Secondly, I think the government has given the three ratings agencies a kind of monopoly. That is, I think it would not be legal for a pension fund to buy some securities on any other than the three rating agencies’ ratings.
March 14th, 2009 at 11:44 am
As I understand the history of the toaster rating agency Underwriters Labratories, this agency became important because of the demand of insurance agencies to only pay for electrical fires if certified electrical components were used. So the ultimate client here were insurance agencies, not the toaster makers.
BTW, my wife’s family made a lot of money in the safe wiring business back in the 1890s, and also put out the first electric waffle maker every (at least in the US), and also was in the toaster business.
March 14th, 2009 at 11:45 am
Yeah, and that status could only be established after how many houses burned down? And that news would be reported by whom? And we could establish the reliability of that source of information how?
Libertarian hypotheticals are so charmingly naive.
.
March 14th, 2009 at 11:46 am
I looked up the definition of Hedge Fund yesterday. To my surprise, they are actually designed to cause the problems we see right now: they are like little money clubs, and operate just like Cramer described in his online confession.
March 14th, 2009 at 11:48 am
Joe,
It is an accounting trick. If you’re going to defend mark to market, you’ll going to have to explain to me how a mark today is probably going to be worth less tomorrow. If the mark today doesn’t reflect the actual price of an asset tomorrow, then why they hell would you fool people into believing that you’ve made these assets more transparent?
Moreover, in good times (e.g. 2 years ago), are you telling me that a mark in an inflated market was more accurate than the marks you’re making today? Citi’s assets haven’t changed in two years Joe, yet they appear to be worth nothing today, having been worth a lot more 2 years ago.
Don’t lecture me on accounting tricks. Mark to market IS an accounting trick.
Do yourself a favor and read this:
http://ashtonadvisory.blogspot.com
That guy (a friend of mine) knows more about this than anyone who’s commented on this stuff (I’d venture to say around the web). Why not put your learned theories on him (a 30 year vet of the financial industry) and see what you get back. If you understand this so well that is…
March 14th, 2009 at 11:49 am
Or, in the case of tainted peanut butter, the lag between knowledge of harm and being forced to stop harming, no matter how profitable it was.
.
March 14th, 2009 at 12:10 pm
Transparency (full information) makes markets efficient, silly.
March 14th, 2009 at 12:19 pm
Forget the free market approach here. We tried it, doesn’t work. Why? Confusion of who’s the actual client and application of otherwise valid free market principles of competition to an endeavor where no one in his right mind should want competition (race to the bottom, anyone?).
Ratings work needs to be done by one entity, directly and harshly accountable, with open standards, and paid for by bond buyers, not bond manufacturers/issuers.
March 14th, 2009 at 12:25 pm
It’s no accident, comrade. Society has long experience with consumer and food product safety. Anyone who thinks food-borne illness would be less of a problem if we relied on free market reputation would do well to re-read The Jungle and google “swill milk”.
Then, take a moment and survey countries around the world for an example of something approximating the libertarian ideal. Doesn’t exist. 19th century America would come pretty close, excepting tariffs. The progressivism that followed wasn’t mass hysteria. We live in a world of regulation because of our experience with non-regulation.
Yes, regulation can fail and bad things can happen, but for spectacular who’d-a-thunk-it failure, you need a market. Today’s situation is not a failure of regulation; it’s a market failure. The mortgage industry invented securitization. The Fed and the SEC and Congress all decided not to regulate them. For a while everyone was able to find a bigger fool, until not. And here we are.
History’s about to repeat itself. Regulation is coming, and you can thank your lucky stars.
Churchill said America could always be counted on to do the right thing after it tried everything else. I suppose it’s also true that no one who lives through a banking crisis wants to rely on banks to regulate themselves. Because, after all, while bankers might think reputation is a fine thing, they also know better than anyone else that cash today is better than reputation tomorrow: there’s nothing like money in the bank.
March 14th, 2009 at 12:32 pm
Anonymous,
See above, what do you mean by transparency? Is it really “transparent” to mark these assets when there is no market? That hasn’t resulted in efficiency (if you haven’t noticed) it’s resulted in seizure (credit markets).
Platitudes are now substitute for analysis.
Also, see the above webpage for more detailed analysis.
March 14th, 2009 at 12:46 pm
No, you’re confusing “failure of regulation” with “failure to regulate.” You can make all the regulations you want but if the regulators, as we saw in ‘01-’09, don’t give a flying fuck then it’s for naught. It’s about human actors, not words on paper. It’s about Johnnys and Joes, not Xs and Os, as the football coaches say.
Yes, there will always be losers and human collateral. That does not mean it’s OK or desirable to choose a mechanism that does not care about those and therefore makes very little effort to minimize them. This is a legitimate role of our government, formed by us for our greater good and all that bullshit.
March 14th, 2009 at 1:00 pm
AutomaticMojo,
While you might not agree with me specifically, I would think that you’d agree generally that there are also regulations that need to be rethought or scrapped. The point of regulation is not regulation for regulations sake. What we need are smarter regulations, which is going to be a combination of getting rid of some, enforcing others, and perhaps creating some new ones (that are better thought out). FASB 157 is one of those “regulations” that needs to be dramatically rethought…As the accounting board and the democrats are slowly beginning to catch on.
March 14th, 2009 at 1:11 pm
We haven’t a free market in the US since the government granted an unconstitutional monopoly to the Federal Reserve a century ago.
The Fed are the ones who created this mess.
Libertarianism is not anarchy, it’s simply democracy applied to money.
March 14th, 2009 at 1:14 pm
Ugly American,
The Fed didn’t create this mess, we all did.
March 14th, 2009 at 2:08 pm
Ed, yes, I agree w/o any reservation that the point of regulation is not regulation for regulation’s sake, and would amplify that to “regulation for regulation’s sake is very bad.”
On the other hand, we have developed an political environment, grown out of the Sagebrush Rebellion I guess, where a loud faction seems to argue that ALL regulation is for regulation’s sake and therefore very bad. It should be obvious, if it was not before, that the power of free markets to make huge misery in the lives of millions is tremendous, and so in great need of sensible and careful regulation and oversight.
Although I do sometimes wish I could buy smack at Walgreen’s, like back in the day.
March 14th, 2009 at 2:09 pm
Way to go Yglesias. That straw man had it coming.
March 14th, 2009 at 2:17 pm
If the mark today doesn’t reflect the actual price of an asset tomorrow, then why they hell would you fool people into believing that you’ve made these assets more transparent? Um, because it’s a SNAPSHOT, reflecting CURRENT value? That was easy.
Citi’s assets haven’t changed in two years Joe, yet they appear to be worth nothing today, having been worth a lot more 2 years ago.
Wow. Are you actually delusional enough to think that the value of Citi’s mortgage backed securities is the same today that it was 2 years ago? Of course not – you don’t actually believe that, you just need a line of patter to keep your firmament from falling down around your ears.
The stink of desperation lies behind arguments this weak, and your sorry little appeal to authority.
I’m going to go back to the dumb-ass argument you made to begin this deflection, because really, nothing I could possibly write could discredit you as much as just pasting this again: Large banks across the country are losing their credit rating because of mark-to-market.
March 14th, 2009 at 2:19 pm
Is it really “transparent” to mark these assets when there is no market?
The market decided your chocolate-covered poop bombs are worthless is still the market in action.
March 14th, 2009 at 2:42 pm
this post would be better if you knew anything at all about product safety. it so happens that the cpsc has almost nothing to do with why your toaster is safe. independent testing labs paid for by the manufacturer, consensus safety standards and the threat of lawsuits do almost all of the work to give you a safe toaster.
March 14th, 2009 at 2:47 pm
No market = $0/share
March 14th, 2009 at 3:27 pm
“That’s crazy,” you might say, “who would trust a toaster-rater who was getting paid by the toaster-makers?”
Came to see if someone already mentioned Underwriter Laboratories.
Mission accomplished.
March 14th, 2009 at 3:29 pm
But the point of UL being a creature of insurance companies (vice toaster companies) is also correct; that’s why it’s called ‘Underwriter’s’
March 14th, 2009 at 3:48 pm
Yeah, the reason why these rating agencies have a monopoly is because the government created one-you have to be approved by one of these three to avoid certain onerous SEC regulations. In a free market, there would be no monopoly and these would be tossed out of business. The government has also given the three credit rating agencies all sorts of protections from litigation, etc. that would not exist in a free market.
March 14th, 2009 at 4:29 pm
The FBI has been too conveniently busy with “terrorism” in the last eight years to investigate white collar crime.
March 14th, 2009 at 4:36 pm
Ed Smithe -
I find your banker friends’ blogposts to be almost incomprehensible, so perhaps you can explain what accounting standard he would choose over mark to market. Reserve accounting? I can’t begin to imagine the process for determining loss reserves on a mezzanine tranche of a mixed-class CDO.
Bloomberg had a good article on how small a portion of these banks’ balance sheets is actually marked to market anyway. Even if the marks on the M2M portion of the balance sheet were too low, the vast bulk of the assets are still valued at basically whetever level the banks want. I’m just not seeing why the Chicken Littles and Steve Forbes of the world are focusing their ire on mark to market.
March 14th, 2009 at 6:37 pm
Matt,
You’ve stepped out of your circle of competence of punditry on this one. Many institutional investors are required to invest in securities highly rated by not just any ratings agency, but a “Nationally Recognized Statistical Rating Organization” (NRSRO). The government (via the SEC), not the market, determines which ratings agencies are NRSROs.
March 14th, 2009 at 8:02 pm
But the point of UL being a creature of insurance companies (vice toaster companies) is also correct; that’s why it’s called ‘Underwriter’s’
So, the “Toaster Company” point stands. In other words, the motivating force here isn’t performance in the market, but some sort of government-based “stick” dangling over the heads of the manufacturers.
Unfortunately, that doesn’t translate to securities very well. You can sue GE if your toaster burns down your house; if CitiGroup issues some debt securities that burn down your retirement, on the other hand, you don’t have a course of action against them, so the motivation on the part of the supplier isn’t the same.
March 14th, 2009 at 8:52 pm
So, the “Toaster Company” point stands
Only on the most pendantic level. UL was founded in 1894 and the first labeling was in 1905 (per wiki the UL site is currently down)
This first labeling is almost 70 years before the CPSC was founded and even a year before the Jungle and the Pure Food and Drug Act came out. Face it, MattY had a ‘1st principles’ approach to his hypothetical without knowing how these things work in the real world. Not an uncommon mistake in blogging (or commentating) – although reading again, he does described the principle on how the market regulates toaster makers.
Reading again I caught this which missed my attention
So instead of losing credibility and going out of business, all three are still in business. And when you think about it, something similar happened with the big accounting firms during the Enron bust.
This is completely false. Prior to Enron there were the big 6. There are now somewhat fewer because Arthur Anderson *went of of business* because of their complicity in Enron (a portion survives as Accenture, but all the big 6 spun of consulting firms in the 90’s)
if CitiGroup issues some debt securities that burn down your retirement, on the other hand, you don’t have a course of action against them
And you don’t think everything has has transpired in the financial markets over the last two years ain’t going to result in decades of litigation?
March 14th, 2009 at 11:45 pm
Prior to Enron there were the big 6. There are now somewhat fewer because Arthur Anderson *went of of business* because of their complicity in Enron
I mentioned this upthread, but Andersen wasn’t the only Big 5 (counting from after the PwC merger) firm to be enmeshed in major accounting scandals. They all were. And the rest are still around.
What I didn’t say upthread was, if every big accounting firm has a big scandal, that suggests to me that the problem isn’t the cupidity of any specific firm or group of people, it suggests that the entire business model of auditors paid by auditees is flawed. So the way to get better audits is not to whack one firm pour encourager les autres, it’s to change the model. Has the model been changed? Maybe spinning off the consulting arms has been enough of a change, but I doubt it.
March 15th, 2009 at 1:04 am
#16 Max Says:
I think you’re missing the point here. It wasn’t so much that the ratings agencies got things wrong, but that their compensation structure gave them no incentives to get it right. It was in their interest to overlook any of the negatives and use the rosey scenario in rating the financial instruments they were being paid to evaluate.
Not true — the ratings were wrong at the time they were issued because they failed to account for the risk involved. That everyone was failing to do that doesn’t make the rating right, because it was in everyone’s interest to underrate the risk — the system was set up for the short-term and not for long term, and for emphasizing the estimated 99% scenario without accounting for the huge downside of that remaining 1%.
We don’t do nuclear power in the US anymore precisely because the public lost patience with the potential downside of the 1% risk after incidents like Three Mile Island. Nuclear power is phenomenally safe in comparison to almost any other industry you can think of, but given the potential downside of any accident, you don’t really want to ignore the 1%.
In the financial case, the meltdown possibility was considered by all and sundry to be so remote as to be not worth considering, and yet, any common-sense evaluation of the situation should have concluded that someday housing prices (and the values of all these crazy financial instruments) were going to have to drop.
Yet, none of the “professionals” in the industry was willing to go on record with that (with very, very few exceptions), and the ratings industries completely discounted that possibility (the AIG situation is laughable — they rated the company and not the actual financial instruments).
As you say, of course, it was conventional wisdom that it couldn’t happen as it did. But it definitely did happen, which means that the judgments on what would or would not happen were WRONG.
Proper ratings agencies should be able to evaluate whether or not conventional wisdom is plausible or not, and in this case, it was pretty darned easy to see that the CW was batshit crazy. But the AAA ratings were still given to AIG’s crap.
The solution, it seems to me, is to restructure the ratings system so there is a minimum of self-interest in the ratings process. That means that perhaps the ratings should be paid for by the consumers of the ratings, not by the companies whose financial instruments are being rated. Consumer Reports is a very small-scale model for this — they are subsidized by the subscribers to their independent testing, not by the makers of the products being evaluated (and accept no advertising, of course).
On the other hand, the consumer credit reporting agencies are a really problematic example of exactly that model. That’s a system that has become punitive against the rated entities (consumers), because the people being rated have very little recourse in forcing the big three (Transunion, Experian and Equifax) to maintain correct information about them. And the reason why is because their constituency (i.e., who pays $$$$ for the information) is the lenders and not the consumers themselves.
But would it be better if they were beholden to consumers? I think it would be, though I’d sure love to hear an economist’s argument on that subject.
What is needed to prevent these ratings shenanigans in the future is a system that forces accountability to the legitimate interests of all the effected parties, and I just can’t see how a government agency is not going to be better than any “free-market” solution, simply because it would eliminate the $$$ incentives to skew the results in favor of whoever is paying the bills.
Would it be perfect?
Of course not!
Anything involving human beings and incomplete information is going to be imperfect.
But the present system is clearly the worst conceivable approach to the problem. The consumer credit bureau model is the second worst, and look how bad that is (identity theft could be elminated if the default were that your credit report could not be released without permission, but that is not in the interest of the lenders, who actually pay the bills, so it will never happen from pure “free-market” forces).
I just can’t see how the best solution is not some kind of government entity (or a government-chartered entity) that does the job with full transparency and oversight, and is responsible to the people via their representatives in Congress and the Executive Branch.
–
David W. Fenton
http://dfenton.com/NoComment/
March 15th, 2009 at 4:22 am
The real answer is that nobody worth their salt should *need* ratings agencies. We should require corporations to disclose sufficient, accurate data that we can rate them ourselves. (This is a matter for SEC regulation.) If you’re not capable of rating something yourself, don’t buy it.
March 15th, 2009 at 8:20 am
There is nothing mysterious about it; what you describe is monopolistic behavior by the ratings agencies and Wall Street in general. They are not competing with each other in a legitimate sense and should be subject to anti-trust laws. Does anyone doubt that there is a fundamental collusion going on with all the Wall Street parties?
March 15th, 2009 at 8:40 pm
Only on the most pendantic level.
No, Kolohe, on a very substantive level, based on the point directly below the sentence you quoted; the toaster companies have insurance companies looking out for their interests here because there is a government stick, beyond the market, motivating them.
And you don’t think everything has has transpired in the financial markets over the last two years ain’t going to result in decades of litigation? I think it doesn’t take decades of litigation when the toaster burns down your house. Justice delayed is justice denied. Investment securities just don’t function that same way as material goods.
March 22nd, 2009 at 12:31 am
So, as someone suggested above, a meta-ratings agency? If there were an independent agency that, at the end of each year, said.
For Moody’s,
x% of AAA rated vehicles defaulted
y% of AA rated vehicles defaulted
…
z% of Junk rated vehicles defaulted
and did the same for the other 9 ratings agencies, would we then not have a platform on which to pay attention to?
I don’t know how to translate that into more money for the ones that did a better job, but it seems that differentiating the various agencies’ competence is the first necessary step for having a market-based system work.
March 23rd, 2009 at 11:59 am
There is a lot of junk in this post and in the comments here. First, the Big 2 CRAs (S&P and Moodys) were dominant well before the SEC gave them quasi-official status in 1975. In fact, originally there were seven SEC-recognized CRAs, but S&P and Moody’s so dominated the market, that Fitch essentially bought up the others to create a viable competitor. This competitor was partly the creation of demand by issuers, since investors in corporate bonds wanted at least 2 ratings, and a third major CRA created some price competition that otherwise wouldn’t exist.
This also underscores how the issuer-pays model may not be the conflict of interest that it otherwise appears to be (at least with regard to corporate bonds — structured products are another matter). If investors demand 2 ratings and you have only 2 (or even 3) players, the CRAs can charge whatever they feel like and give the issuers whatever rating they feel like, because the issuers have no choice in the matter. It is only when issuers can ratings-shop (possible with structured products because institutional investors typically only required one rating of certain tranches) that the conflict of interest arises. Of course, this says nothing about quality — but we’re talking corruption here, right?
Third, the largest CRAs dumped the subscription-based model before the government started using ratings widely in regulation. The issuer-pays model was fallout from the creation of the fax machine, since the ability for subscribers (or employees of subscribers) to rapidly share ratings with others created a tragedy of the commons problem. As it stands, investors look at ratings the same way I look at Internet news — nice to have, but I’m not willing to pay for it. At least for most of it. CRAs are the same way. If you forced a change to a subscription-based model, most corporate bonds and most structured finance products (such as they continue to exist) would not be rated. Maybe not a bad thing, but we shouldn’t fool ourselves that this would lead to greater ratings quality.
Also, the subscription-based model has its own conflicts of interest, doesn’t it? If I’m a small CRA and a hedge fund is a major source of my income and I know that that fund is invested heavily in Bond X, what are the odds that I’m going to downgrade Bond X in a public fashion? And if I do, you think I might be under some pressure to let that client know of the downgrade beforehand?
Finally, the SEC didn’t even have the legal authority to regulate CRAs until mid-2006, with the regulations in place by 2007. Now, you can certainly criticize the SEC for using ratings in regulation in the first place. But, if you do so, you need to be fair about it. First, if you are going to use ratings in regulation (for net capital haircuts and the like), are you going to let the financial firm use just anyone’s ratings? If so, I’ll start a rating agency tomorrow. (Wait, I guess the SEC is already doing that — pretty much anybody is recognized these days.) Doesn’t that create a very obvious conflict of interest, particularly for structured products that are privately traded (i.e., subprime CDOs) that the SEC doesn’t regulate and information about which is not made public?
However, if you don’t allow ratings to be used, does that mean you let the financial firms determine their own capital reserves? If I’m invested in “safe” assets (i.e., cash), should I have to have the capital reserve requirements as someone invested in junk bonds? If so, why would I be invested in cash, since the possible return on junk is so much higher? But if you do allow for different reserve requirements according to the risks the bank is taking on, who determines what is “safe” and what is “risky”? The firms themselves? No conflict of interest there! The SEC? With what staff and what budget? And you really think the government is any good at that kind of thing?
All I’m saying is that there are lots of problems here, but the solutions aren’t as obvious as you might think. And if you don’t know what you’re talking about (e.g., Congress), you’re very likely to make a bad situation worse.