Rating For Fun And Profit

Via Ezra Klein, James Surowiecki has a story about the nation's credit ratings agencies - Moody's, S&P, Fitch - who gave toxic waste sterling ratings that encouraged investors to buy them, leading to a collapse of the financial system. You can add to this the fact that the ratings agencies are funded by the banks, who have a compelling interest in having their crap be given triple-A ratings. But Surowiecki argues that government needs to take some of the blame for this as well.

[O]ver the years the government has made the agencies an increasingly important part of the financial system. Rating agencies have been around for a century, and their ratings have been used by regulators since the thirties. But in the seventies the S.E.C. dubbed the three biggest agencies — S. & P., Moody’s, and Fitch — Nationally Recognized Statistical Rating Organizations, effectively making them official arbiters of financial soundness. The decision had a certain logic: it was supposed to make it easier for investors to know that the money in their pension or money-market funds was going into safe and secure investments. But the new regulations also turned the agencies from opinion-givers into indispensable gatekeepers. If you want to sell a corporate bond, or package a bunch of mortgages together into a security, you pretty much need a rating from one of the agencies. And though the agencies are private companies, their opinions can effectively have the force of law. The ratings often dictate what institutions like banks, insurance companies, and money-market funds can and can’t do: money-market funds can’t have more than five per cent of their assets in low-rated commercial paper, there are limits on the percentage of non-investment-grade assets that banks can own, and so on.

The conventional explanation of what’s wrong with the rating agencies focusses on the fact that most of them are paid by the very people whose financial products they rate. That problem needs to be fixed, and last week the S.E.C. proposed new rules to address conflicts of interest. But there’s a much bigger problem, which is that, even though nearly everyone knows that the agencies are compromised and exert too much influence, the system makes it impossible not to rely on them.

Predictably, despite the ratings agencies' central role in the financial crash, nothing has changed with them, because the government has stamped them with authority and investors need their numbers to carry out deals, pretty much by law.

If government created this monster, they need to play a role in reversing it. In New York, inspectors with the state Insurance Department are considering dropping Moody's from its list of approved ratings agencies. The National Association of Insurance Commissioners (who collectively oversee an industry with $3 trillion in rated bonds) has proposed the same for the entire Big Three. And Jerry Brown has issued a subpoena to the Big Three agencies to investigate the ratings they gave to subprime mortgages. But ultimately, while this may keep the ratings agencies in line, you need to eliminate the official imprimatur from government and force the ratings agencies to compete on their own credibility. Further, the regulatory requirements actually force investors to sell downgraded securities quickly, leading to panic selling based on ratings that don't have a lot of backing behind them. That needs to be tweaked as well.

Surowiecki explains why this won't happen:

Oddly, the ratings system, broken as it is, remains attractive to many investors who have been burned by it. For one thing, it provides an easily comprehensible standard: without it, we’d need to come up with new ways of measuring risk. More insidiously, the ratings system provides a ready-made excuse for failure: as long as you’re buying AAA-rated assets, you can say you’re being responsible. After the housing crash, though, we know how illusory those AAA ratings can be. It’s time for investors to face reality: working with a fake safety net is more dangerous than working without any net at all.

I think, given the safety net under the bottoms of the major banks, that they'll take that fake one from the ratings agencies and live with it, thank you.