Fixing the Ratings Agencies
Matt Yglesias comments on the packaging of crappy loans back in the heyday of the credit bubble:
The mysterious thing isn’t that people made bad loans that they were able to package and sell off, the mysterious thing is that they found buyers for the securities.
Ultimately this looks to me to go back to the ratings agencies, an issue [Barney] Frank sort of dodged. But the ratings agencies are private for-profit companies that also enjoy a kind of government-sponsored monopoly status. In theory their behavior should be subject to market discipline, but in practice it’s not. They screwed up badly. But while lots of companies have gone bankrupt and lots of people have lost their jobs, the ratings agencies are all still in business. And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.
No question about it: over the past decade ratings agencies were, at best, negligent, and at worst, perpetrators of outright fraud. "It could be structured by cows and we would rate it" is surely one of the all-time great quotes of the bubble era. And the fact that agencies shared their models with issuers so they'd have an easier time tweaking their products to get high ratings is prima facie evidence of corruption. Slapping a AAA rating on every cobbled-together junkpile that slithered its way out of a Wall Street structured finance group certainly helped fuel the fantastic expansion of risky investments that all came crashing down in 2008.
Still, I have to admit that over the past year ratings agencies have moved down my personal league table of bad actors. If you take a look at the list of possible causes for our recent financial meltdown here, I probably would have put the ratings agencies in the top five a year ago, while today I'm not sure I'd even put them in the top ten.
Partly this is because I've become more sympathetic to fundamental macroeconomic explanations for the bubble: easy money, current account imbalances, massive abuse of leverage, and huge increases in both debt and risk that were masked by ever more baroque credit derivatives. Partly it's because widely accepted1 risk models based on CDS spreads mostly produced the same results as the ratings agencies. Partly it's because the negligence/fraud involved in producing high ratings was pretty clearly a two-way street: buyers and sellers of structured investments were every bit as anxious to get them as the ratings agencies were to provide them.
Beyond that, I'm also a bit flummoxed about what the answer to the ratings agency problem might be. There's probably a reasonable regulatory solution for fraud and negligence, but there seems to be wide agreement that the real problem is incentives: since issuers are the ones paying for ratings, it's inevitable that agencies are going to lean into the wind to provide ratings the issuers like. I've read dozens of proposals for ratings agency reform, but the only one that really gets at this fundamental conflict-of-interest problem is to simply do away with them and turn debt rating into a government function. I'm a little skeptical of that, though, since it's not at all clear to me that a government agency could hire the kind of talent it takes to keep up with Wall Street's rocket scientists. What's more, it's not at all clear to me that anyone — Fed regulators included — would have rated SIVs much differently during the boom years than the ratings agencies did.
So....I'm not sure what the answer is. Tighter regulation would obviously be welcome, but how do we get rid of the underlying conflict-of-interest problem? How do we align agency incentives in favor of long-term accuracy? How do we encourage real competition between the agencies, rather than a race to the bottom? None of the regulatory reforms I've seen really get at this in a fundamental way. Does that mean that a government takeover is the only real answer? Or does it mean that there is no real answer and we've collectively decided to shrug our shoulders and allow this to happen all over again in a few years? Somebody should ask Barney Frank.
1Whether they should have been widely accepted is a different question. But they were.