Paul Krugman in NYT:
The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.
No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.
What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.
The rating agencies began as market researchers, selling assessments of corporate debt to people considering whether to buy that debt. Eventually, however, they morphed into something quite different: companies that were hired by the people selling debt to give that debt a seal of approval.
Those seals of approval came to play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.
It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt — which increasingly meant Wall Street firms selling securities they created by slicing and dicing claims on things like subprime mortgages — could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.
And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.
These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. Paul McCulley of Pimco, the bond investor (who coined the term “shadow banks” for the unregulated institutions at the heart of the crisis), recently described it this way: “explosive growth of shadow banking was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out fake IDs.”
Tim Fernholz at Tapped:
The financial-reform bill in the Senate does not do a ton to solve this problem. That’s in part because it’s a difficult problem to solve. Ratings agencies are paid by the people selling debt — an obvious conflict of interest — but no one else wants to pay for them. Someone buying debt has a better incentive to pay for a rating but that creates a free-rider problem where one buyer funds ratings for an entire universe of potential purchasers. The whole thing is a strange phenomenon of the market.
In the meantime, what we’ll get is tinkering around the edges: A new office in the SEC, new examination authorities, disclosures of methodology from the raters, some internal firewalls between sales staff and raters. But you still have sellers paying for ratings. Paul Krugman thinks this proposal to have the SEC essentially run the process and act as a middle-man between sellers and raters might be a better idea.
The other possible solution, mentioned in that proposal and hinted at in the legislation, is to introduce actual competition among the ratings agencies. The current legislation would stop regulators from relying on these agencies when they make decisions in order to take away their legal weight and create better incentives; currently, ratings agencies seem as responsible for the quality of these securities as the companies issuing them. However, as another proposal suggests, further steps to lower the regulatory barriers of entry to potential competitors of the existing agencies might be an even better answer.
This may be a weird case where smart deregulation could bring greater safety to the market.
Jennifer Rubin at Commentary:
A reader calls my attention to Paul Krugman’s column. Krugman gets his share of criticism around here, so it’s only fair to point out when, as the reader put, he “actually makes sense.”
This at least seems to be an area worth exploring in greater depth. But as Krugman points out, the current legislation doesn’t do much about this issue. (”The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in ‘knowing or reckless failure’ to do the right thing. But that surely isn’t enough, given the money at stake — and the fact that Wall Street can afford to hire very, very good lawyers.”)
One problem with huge reform efforts is that they usually focus on the wrong problem. In this case, the frenzy to eliminate risk — an impossibility if one wants to preserve entrepreneurial dynamism — has obscured more productive activities, including reduction or elimination of conflicts of interest, which is a worthy legislation goal. But “increasing rating companies’ independence” doesn’t sound nearly as exciting as “going after Wall Street greed.” So we never quite get around to it.
Lawrence Wright at Roosevelt Institute:
The three large US-based credit rating agencies – Moody’s, Standard & Poor’s, and Fitch – provided excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade, actions that played a central role in the financial debacle of the past two years. The strong political sentiment for heightened regulation of the rating agencies – as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) – is understandable, given this context and history. The hope, of course, is to forestall future such debacles.
The advocates of such regulation want to grab the rating agencies by the lapels, shake them, and shout “Do a better job!” But while the urge for expanded regulation is well-intentioned, its results are potentially quite harmful. Expanded regulation of the rating agencies is likely to:
- Raise barriers to entry into the bond information business;
- Rigidify a regulation-specified set of structures and procedures for bond rating;
- Discourage innovation in new way of gathering and assessing bond information, new technologies, new methodologies, and new models (including new business models).
As a result, ironically, the incumbent credit rating agencies will be even more central to the bond markets, but are unlikely to produce better ratings.
The term “deregulation” is normally associated with the right, but there’s a long tradition of progressive deregulation in this country aimed at bolstering competition and forcing firms to be disciplined by each other rather than by captured regulators. Ted Kennedy, for example, played a key role in bringing price competition to air travel and trucking. And via Tim Fernholz, here’s a proposal in that spirit from Lawrence Wright at the Roosevelt Institute to unravel the regulatory cartel that keeps the ratings agencies in business no matter how badly they screw up.
I’m not sure this is the be-all and end-all of the issue. Ultimately, I think some kind of ratings agency “public option” (to coin a phrase) could be a good idea. But as a first step, deregulation makes sense to me. The way it works right now, for many purposes you have to rely on one of the established agencies. Consequently, there’s no real market discipline on their myriad conflicts of interest. It’s a recipe for disaster, it was a disaster last time around, and while there are good ideas in the main regulatory reform bill I don’t think it addresses the ratings agencies in any kind of satisfactory way.
Dean Baker at The Center For Economic And Policy Research:
The obvious way to fix the conflict is to take away the hiring decision from the issuer. The issuer would still pay the rating agency but a neutral party — the SEC, the stock exchange on which the company is listed, the local baseball team — would make the decision as to which agency gets hired.
Some of us have been pushing this one for a while (e.g. here and also Plunder and Blunder), but Congress has preferred much more complex regulations that would have no impact on the basic conflict of interest. However, Paul Krugman comes to the rescue in his column today. Maybe now someone in Congress will be able to think clearly on this issue.
I guess this is my question: if you do this, the ratings agencies no longer have any incentives to do much of anything. There are three of them, and presumably each one would get a third of the business at a price set by the SEC. So their incentive would be to hire the cheapest possible analysts and cut costs to the bone. The result would be ratings agencies even less able to cope with complex modern securities than the current ones.
This is what stonkers me about the ratings dilemma: there just doesn’t seem to be any good answer. Turning the ratings agencies into regulated utilities might be better than the current situation, but not by much. And if you’re going to do that, why bother with ratings agencies at all? Why not just have the SEC provide ratings?
I’ve read other proposed solutions too. Open up the business to more firms, for example, or pay the agencies based on the accuracy of their ratings. But the first doesn’t really get at the conflict of interest, and the second is difficult because it often takes years before you know if a rating is accurate.
I remember once someone telling me that after every financial crisis ever, the ratings agencies are always rolled out as sacrificial lambs. They had always been too optimistic, or too stupid, or too corrupt, or something. And then there’d be a hue and cry about “fixing” them, even though the real problem was that every single person on Wall Street, buyers and sellers alike, had wanted them to do exactly what they did: help inflate a bubble that made everyone truckloads of money. The hue and cry, he suggested, was more a way of deflecting blame from the real villains than it was a serious attempt to address an underlying problem.
I don’t remember who told me that, and I don’t even know for sure if it’s true. It’s stuck with me, though. I’m just not sure what the answer is here.
The ratings agency business has two apparent settings: Hopeless conflict of interest or heavily regulated utility with an incentive to cut costs. But they play a very important role in the system. So why not make them — or some basic version of them — public? It would be better for both accountability and incentives.
The obvious problem is that a public rating agency might be too conservative, but on the one hand, I’m not sure that’s a bad thing, and on the other hand, the market could always ignore the rating. It’s much more dangerous for the ratings agencies to be paid to tell the market what it wants to hear rather than for them to be erring on the side of conservatism and forcing the market to think hard about whether the thing it wants to hear is really true.
EARLIER: In A Bad Mood About Moody’s
UPDATE: More Yglesias