Talk has turned to the ratings agencies. The problem of these agencies has produced consternation across the ideological spectrum. They're the kind of private institution that anarcho-capitalists count on to substitute for government regulation in their ideal world. But just as governments often exhibit the same pathologies we demand they cure in private markets, in this crisis, private institutions seem to have demonstrated a classic public choice problem: the benefits of sound ratings are distributed, but while the costs are concentrated. It's thus easier for banks to undermine the ratings than for all those zillions of people who benefit from good ratings to organize to push the system back towards balance.
One could also argue that, to the extent that fraudulent lending was a problem, this was the source of it. In theory, borrowers have just as much incentive to get the mortgage broker on their side as the lenders do--there's a fixed sum of money passing back and forth. But the lenders make a lot of loans, and the borrowers only take one, which makes it easy for the lenders to develop a system which encourages brokers to screw their clients.
I don't know how much this actually happened, because there is no--I repeat, no--good data yet on mortgage broker fraud, and it's very possible that this wasn't a significant problem (no matter what you've read in the New York Times). There are countervailing forces that mitigate against it--competition between brokers, and the fact that each loan is a life-or-death matter to borrowers in a way that it simply isn't to a bank. But if it was a problem, this is probably why.
I don't know what to do about this. The normal answer is regulation, but the ratings agencies get watched pretty closely by the SEC, which is why the whole thing makes liberals queasy. Also, the regulations on them were just tightened in 2006, which isn't helpful when you are looking to do something!
"They're the kind of private institution that anarcho-capitalists count on to substitute for government regulation in their ideal world."
Can you, are you allowed to, get your Facts straight?
Those 'Rating Agencies'-Moody's, S&P, Fitch, have been granted, by statute, Government Monopolies..
hardly 'anarcho-capitalist'..
If your Masters have yet to, further, Clue you in, the key to effective agitprop/propaganda is not to be so obviously wrong..
Mark, that's not exactly right--they are on the list of agencies whose ratings grant SEC safe harbor, though we are now moving towards a more formal status. But I really don't think it's plausible to argue that the problems we saw in the agencies are a result of their SEC status.
Megan,
Their, the 'Ratings Agencies', position is enhanced/subsidized by that Gov't Fiat that serves to restrict Competition from other, possibly better, 'Ratings Agencies'.
As we've seen, for all too long, lack of Competition breeds ill, not well.
There's, also, the fact that those 'Ratings Agencies' were/are paid by the Manufacturer, not the Purchaser, of the products being rated..hardly a scheme that promotes maximal integrity..
The only reliable protection against over-leverage in general is greater liability for the consequences falling on the parties responsible for the decisions to fall into temptation. The key individuals are the responsible decision makers at the investment banks. The only measure that works is therefore greatly reducing the cover these ladies and gentlemen receive from the legal principle of limited liability. If these financial institutions are to be formally regulated, I guess that is the price their bosses ought to pay for the privilege.
It won't work every time; as pretty massive personal exposure did not do the trick at Bear Stearns. But it will balnce up the incentives better than any other measure.
As for the ratings agencies, I used to enjoy the plodding ologopolistic competition in their patch of the Wall St. jungle. But like earlier apparently viable dinosaurs, they got tempted into a tar pit. If we were starting again, all future authorised rating agencies would be paid via a very small annual commission payable by the holders of every product that they currently rate. Modern payments systems can handle that sort of volume of picayue amounts; as I am reminded every time I use a credit card to pay a toll for a short distance of road.
the benefits of sound ratings are distributed, but while the costs are concentrated.
Blah.
Anyone basing decisions on a rating system they don't understand should be bounced from the business anyway---it doesn't matter who paid the bill.
Further, you really didn't need a ratings service to understand that ARMs financing where, the borrower didn't have the ability to make payments at an increased monthly rate, coupled with the fact that Greenspan money printing would have to eventually stop, was a nuclear accident waiting to happen.
There was plenty of time to spot this stuff. See for example:
http://www.economicpolicyjournal.com/2006/06/this-babe-is-betting-big-that-bernanke.html
and
http://www.economicpolicyjournal.com/2008/06/ex-girlfriend-construction-worker-and.html
Megan,
"Mark, that's not exactly right--they are on the list of agencies whose ratings grant SEC safe harbor, though we are now moving towards a more formal status."
The SEC maintained a de facto oligopoly of rating agencies because it was so reluctant to confer the "nationally recognized, statistical rating organization" (NRSRO) designation on any new rating agencies. Prior to the designation of Egan-Jones as an NRSRO at the end of last year, when was the last time a new ratings agency was given this designation?
In economic theory, at least, oligopolistic competition--essentially, what these agencies were doing--is not sufficiently different from pure competition to account for the problems Mark wants it to explain. Once you have three entrants in a market who are legally prevented from colluding and have limited ability to tacitly do so, you should see the main benefits from competition on price and product.
Megan,
Unlike previous companies designated as NRSROs (Moody's, S&P, Fitch), Egan-Jones is not paid by the issuers of the securities it rates, so it doesn't have that inherent conflict of interest. Had the SEC designated it an NRSRO earlier, the other NRSROs might have been compelled to eliminate that conflict of interest as well. That could have resulted in more realistic ratings across the board, and fewer triple-A ratings being given to sketchy mortgage-backed securities.
Megan,
let's pretend that we can't move the goalposts..
this: "In economic theory, at least, oligopolistic competition...", is a long way from: "the kind of private institution that anarcho-capitalists count on to substitute for government regulation".
ya know, theories are all well, and good, when used as placeholders during hypothetical discussions, but they fail, miserably, as substitutes for empirical facts.
And, Megan,
since I won't play this game: "...is not sufficiently different from pure competition to account for the problems Mark wants it to explain.", I'll ask you, how do you prove this: "have limited ability to tacitly do so"--referring to "collusion" amongst firms in a Oligopolistic marketplace, in general, and with the NRSROs in specific.
Thanks Dave, for providing the correct Bureaucratese..
Or, Megan,
feel free to respond to Dave's 04:12 post..
file under "Ripley's", but I didn't see that one before my own @ 04:49..
Sell Italian bonds. Italian public debt has reached a record high at 1646,7 billion euros.It is worse than 1992 when the country went very near to declare default(insolvency)
In the abstract, there isn't a problem here: stupid investors believed the blurb from institutions paid by the originators of the products they were buying, rather than paying for their own professionals, and they got burned. On that level, there is no institutional or market failure, and everyone got what they paid for.
The problem is the liability (or lack of it) in fund managers who relied on these ratings when making decisions on behalf on unsophisticated investors. On that level, the safe harbour of NSRO should be abolished, and fund managers should have to rely on independant ratings agencies.
You're welcome for the "bureaucratize", Mark. A question I vaguely recall someone asking here last year was why the buyers of these securities -- pension funds, etc. -- didn't pool their resources and fund their own independent rating agency to insure they'd get objective ratings. The answer was that such a ratings agency wouldn't be an NRSRO, and various regulations required the pension funds to buy only securities rated highly by NRSROs. So by limiting the universe of NRSROs to issuer-funded ones, the SEC in effect perpetuated a business model with an inherent conflict of interest.
It's also worth noting here that Warren Buffett probably could have had an impact here, had he been paying closer attention. His Berkshire Hathaway is the largest shareholder in Moody's. Had Buffett questioned the ratings Moody's was given out and influenced them to be more conservative, Moody's probably would have lost some business to the other NRSROs during the credit boom, but it would have more credibility, and be in a better position now.
Contra Megan, during the 1980s and 1990s the SEC outsourced a large areas of its regulatory authority to the NRSROs without watching over the NRSROs in the least. In fact, some MBS CDOs, and SIVs would be illegal under Federal securities laws without SEC rules and exemptions that rely in part on the fact that the entity is rated by an NRSRO. Now the SEC is in a rush to appear to be "doing something" about
the rating agencies, without knowing what to do.
Megan, with all due respect, I don't think you know much about this issue (about which I have a fair amount of background). I hope you know more about the other issues you make pronouncements about (about which I know little.)
To answer Megan's question, one option for reducing abuses in this context is to make the ratings agencies (and the mortgage brokers for that matter) fiduciaries with all the duties and the resulting consequences (especially the liability) that flows from that status. Fear is a powerful motivator, and fear of nasty punishment for betraying the duty of loyalty is a formidable threat.
In answer to the question about which rating agencies were given NRSRO status before Egan-Jones last year, I think the answer is DBRS, A.M.Best, JCRA and R&I. And the reason Egan-Jones is paid by subscribers instead of by issuers (i.e., manufacturers) is because no issuer will buy a rating from such a small outfit as Egan-Jones. Egan-Jones lobbied extensively for the 2006 law on rating agencies as a way to force the SEC to grant it NRSRO status, recognizing that this would be the only way it could increase it's subscriber base. Basically, it needed the press. But ratings have characteristics of public goods -- once an agency (a widely respected agency) gives a rating, information about what that rating is travels through the market at the speed of the internet. Why would an investor pay for that information when he or she can get it for free? That's why even the moderately-sized rating agencies charge issuers rather than subscribers. (And to say that issuers are the primary conflict of interest is to ignore how financial markets work. If you are Moody's or S&P, no particular issuer provides you with more than 1% or so of your income. By contrast, a single subscriber could provide a small rating agency with more than 10% or its income -- and you really think that rating agency is going to downgrade a bond in which that big client has invested heavily?)
All that said, Megan is wrong that the SEC closely regulates these agencies, with that regulation tightened in 2006. Until 2006, the SEC did not regulated them at all. Now, the SEC regulates them for conflicts of interest, but is prohibited from regulating them for quality or their methodologies. Since the SEC is the single biggest ratings "consumer" (since it mandates that banks that have debt held in certain bonds rated very highly by certain rating agencies can hold less in capital reserves), a lot of investors "piggyback" on the SEC's decisions about which rating agencies are OK for these regulatory purposes. And everyone else piggybacks on this NRSRO designation as well -- local governments, private contracts, etc. After all, if you are an investment manager and you are parking your money in cash-like instruments and things go south, you can CYA much better if you point to the fact that those instruments were deemed "safe" by an agency approved of by the SEC.
The problem has always been that the SEC was not judging the quality or accuracy of the ratings. It was instead judging acceptance by the market -- which had a feedback loop built into the system, given the SEC's own NRSRO designation. The problem now is that since passage of the 2006 Credit Rating Agency Reform Act, the SEC is willing to increase "competition" by applying the NRSRO designation to every Tom Dick and Harry rating agency, but again without consideration of accuracy or quality. And without addressing the fundamental market problem created by the NRSRO designation itself. So what you had before was a small number of incompetent NRSROs, but who at least had the virtue of being too big to be bullied by the issuers they rated. (After all, they were an oligopoly.) Now, you've got a large number of NRSROs all competing with each other, but all of which may be used for regulatory purposes as if they were all of equal quality.
If that's not a recipe for moral hazard, I don't know what is.
Once you have three entrants in a market who are legally prevented from colluding and have limited ability to tacitly do so, you should see the main benefits from competition on price and product.
Posted by Megan McArdle | July 6, 2008 1:52 AM
so much for Theory, way to go MM!~
if you weren't so busy regurgitating the talking points that have prepared for you--you might have had some time to do some actual Research..
http://www.sec.gov/news/studies/2008/craexamination070808.pdf
News release: "The Securities and Exchange Commission today released findings from extensive 10-month examinations of three major credit rating agencies that uncovered significant weaknesses in ratings practices and the need for remedial action by the firms to provide meaningful ratings and the necessary levels of disclosure to investors.
Under new statutory authority from Congress that enabled the SEC to register and examine credit rating agencies, the agency's staff conducted examinations of Fitch Ratings Ltd., Moody's Investor Services Inc., and Standard & Poor's Ratings Services to evaluate whether they are adhering to their published methodologies for determining ratings and managing conflicts of interest. With the recent subprime market turmoil, the SEC has been particularly interested in the rating agencies' policies and practices in rating mortgage-backed securities and the impartiality of their ratings...
The Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies describes the significant weaknesses in the rating agencies' processes in rating subprime RMBS and CDOs linked to subprime residential mortgage-backed securities from January 2004 to the present."