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Earlier this morning I wrote about the practice of banks shopping around to get the best ratings for their latest structured investment vehicles. But Robert Waldmann says it was much worse than that:

If only the ratings agencies had waited for financial firms to come through their doors bearing rocket science securities the conflict would have been less severe. The ratings agencies decided to consult too (remember how well that worked out for Arthur D Anderson). So they charged large fees to help financial firms design financial instruments. This was a new practice and the blatant conflict of interest was obvious.

Not only is the conflict of interest worse, but Robert says there’s an additional, subtler problem here: when both the bank and the rater use the same models, there’s only one opinion about how safe a security it. If they used separate models, at least you’d have a little bit of a check.

However, I think the problem mostly remains. If all three of the ratings agencies had been tougher on new rocket science assets, the whole huge industry would never have existed and all of them would have been poorer. A reasonable rule would be that no asset gets AAA unless an asset which is identical except for maturity dates paid on time and in full in each of the past 3 recessions — that is no AAA for new stuff for decades — no exceptions. Obviously with or without agency shopping, they wouldn’t have done that. So I don’t really have a solution.

Neither do I. For the moment, anyway.

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