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Rating the Raters


Steve Pearlstein had a nice column last Friday on rating agency reform -- which is arguably the most important aspect of financial regulation reform. They're the one player whose proper functioning could have prevented, well, everything. If all the trash had been rated as trash, that would have been the end of the game.

Instead, it was all rated as AAA gold. It's hard to say how many traders understood those ratings were nuts and how many were genuinely fooled. But it was a problem. And it was, in some ways, a predictable one: The ratings market is structured in a very peculiar way. Banks pay the rating companies to analyze their products. There are multiple companies, so they compete for the business of banks. And as you might expect, banks are interested in the company that will help them make the most money, not the one that will consistently downgrade their products. That means that if you want to be the rating agency that makes the most money, you'd better be the one that helps the banks make the most money. And the three major raters -- Standard & Poor's, Moody's and Fitch -- all competed to play that role.

It wasn't always this way. Pearlstein gives some history:

[P]eople who use a good or service should also be the ones who pay for it. That's how it works in most markets. And when it doesn't -- health care is a good example -- things tend to go awry.

It used to work that way in the credit-rating business as well, with investors paying directly for ratings and analysis through some sort of subscription arrangement, or indirectly through their brokers. But starting in the mid-1970s, after a number of high-profile bankruptcies, people decided it was important to make credit ratings publicly available to all investors. Companies that issued bonds began paying for the ratings themselves, and it didn't take long before agencies figured out that it was better for business if their ratings were a bit higher and their analysts were a bit slower to issue downgrades. By the time collateralized-debt obligations came along, it was not uncommon for agencies to provide issuers with behind-the-scenes advice on how to structure their new products to get the highest rates. The interests of the ratings agencies came to be perfectly aligned with those issuing the securities rather than those buying them.

The problem with ratings agencies is not that they're too big to fail. It's that they're too important to fail. The main solution you hear about is blind assignment. A public or nonprofit agency would simply direct a rater to each product. The rater's constituency would, in that scenario, be the agency, not the bank. That would at least rid the market of the perfect storm of misaligned incentives that plagued it until now.

I think you need to go further, however. So long as sellers are funding the ratings, it's hard to imagine raters being totally deaf to their needs. Buyers need to fund the ratings. But since there's no particular buyer anymore -- instead, the information is public -- then the public needs to be the purchaser, turning the rating agencies into something akin to public utilities.

The financial regulation conversation tends to focus on limiting leverage, and for good reason: That's the best way to keep a severe problem from contaminating the entire system. But radically reforming the rating agency market is probably the best way to keep the problem from getting so severe in the first place.

Photo credit: By Ethan Miller -- Getty Images

By Ezra Klein  |  September 21, 2009; 5:47 PM ET
Categories:  Financial Regulation , Solutions  
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Is there anything that Klein wouldn't nationalize?

Fitch, Moody's, and Standard & Poor's are already heavily (though incompentently) regulated by the SEC, a system (as with much that government contrives) that lulls people with a false sense of security.

Intelligent people will no more trust the government issued "ratings" than they should believe that the FDA keeps the food supply system safe, or that Fannie and Freddie are competently overseen, etc., etc. Trust in government is entirely misplaced, except by pea-brained collectivists who don't know how bad it can get.

Posted by: msoja | September 21, 2009 6:53 PM | Report abuse

This topic is not getting much attention, and I thank you for posting it, Ezra.

My biggest fear is that Geithner, Dodd, and Frank will go easy on overhauling the rating agencies. You hear a lot about leveraging and capital requirements for these banks but very little about rating agencies. If the lessons of Enron and the 2007-2008 debacles don't impart some wisdom into our collective heads, then we deserve financial apocalypse 3.0.

This is like asking Walmart, Burger King, Ford, Home Depot, etc to rate their own consumer products. The incentive to be corrupt would be very high. Unfortunately, this is the abysmal financial rating system we have today.

Buyers, i.e. consumers, should be the ones in charge of rating goods, not the sellers.

Posted by: jasonr3 | September 21, 2009 7:20 PM | Report abuse

"My biggest fear is that Geithner, Dodd, and Frank will go easy on overhauling [...]"

"Buyers, i.e. consumers, should be the ones [...]"

Those two statements are irredeemably contradictive.

Posted by: msoja | September 21, 2009 7:49 PM | Report abuse

Jason: Not to make Klein drool at the idea of more government oversight, but would you patronize Burger King based on ratings cobbled together by the likes of Chris Dodd and Barney Frank? I mean, after Burger King's lobbyists make their perfectly legal and appropriate visits to your stalwart champions, won't the resultant "ratings" be exactly worth the "system" currently in place? (hint: it's called advertising.)

You know the reason Kellogg Co. lost $70 million over a salmonella outbreak this year, but Nestle didn't? Kellogg trusted the FDA to investigate Peanut Corp., while Nestle trusted itself to make the judgement. You could look it up.

Think about that next time you go to buy a stock or bond. Who you gonna believe? The SEC (or whatever government agency that collectivists invent)? Or yourself, or someone that can cater to your trust by offering a rating service that you are free to accept or decline based on the merits which you are free to investigate? I know what I choose (the only problem being that I end up paying for Klein's "solution", too.)

Posted by: msoja | September 21, 2009 8:08 PM | Report abuse

"like asking Walmart, Burger King, Ford, Home Depot, etc to rate their own consumer products."

Actually it's more like assuming the gun being pointed at you isn't real because Walmart's policy is not to sell guns to criminals.

People need to understand the limitations of a ratings agency and do their own homework.

Posted by: bmull | September 21, 2009 8:30 PM | Report abuse

Ezra - if you're going to make the case that bond ratings should become a government function you're going to need to explain why the government's ability to effectively rate bonds would be any better than the SEC's ability to regulate the like's of Bernie Madoff. I believe you've complained about regulatory capture making the SEC ineffective. So why would a new gov't bond rating agency be any better?

I think it's highly unlikely that the gov't would do even a remotely competent job.

Posted by: mbp3 | September 21, 2009 10:10 PM | Report abuse

I agree that blind assignment is no where near enough of a reform. I don't think the key problem was rating agencies competing for business. I think the problem was exactly that "If all the trash had been rated as trash, that would have been the end of the game. "

The game involved a whole lot of new instrumens for the rating agencies to rate. They each had to make basic decisions along the line of "if no asset of this type has existed during a recession so we can't tell what will happen, can we rate it no higher than A ?"

They all had to think "If we don't rate the senior most tranches AAA that's the end of the game and that end will deprive us of $ X so ..."

The rating agencies had the power to decide if there was to be a huge new set of assets to be rated implying a huge increase in their revenue.

This incentive would be unchanged if the fees for rating each single asset were paid to a rating agency chosen at random.

Posted by: rjw88 | September 21, 2009 11:57 PM | Report abuse

"[P]eople who use a good or service should also be the ones who pay for it. That's how it works in most markets. And when it doesn't -- health care is a good example -- things tend to go awry. "

If you're going to accept that argument for ratings agencies then you've also got to accept it for health care.

Which means that we need more market and less government in health care, no?

Posted by: timworstall | September 22, 2009 6:53 AM | Report abuse

I believe in many cases odd securities like CDOs built on mortgages and mortgage backed securities acquired AAA status for some higher tranches by virtue of being insured by credit default swaps issued by AAA entities (like AIG). While I agree that some rethinking of the ratings agencies is necessary, this CDS-based underwriting is a rather different thing than direct ratings agency FAIL.

Posted by: bdballard | September 22, 2009 2:35 PM | Report abuse

rjw88 has it exactly right, in my opinion. The conflict that caused the most damage was not being paid by the sellers. It was the huge incentive to give high ratings to new asset classes, thus opening up whole new revenue streams.

Also, I think this is largely a false dichotomy: "It's hard to say how many traders understood those ratings were nuts and how many were genuinely fooled."

I would argue that most of them were neither fooled nor understood they were nuts. Most, though not all, came to more or less the same opinion independently. People outside the industry seriously underestimate how unanticipated (again, within the industry) the confluence of events that became the credit crisis was. A very large proportion of participants bought the instruments with their eyes wide open. I don't mean to absolve either the rating agencies or the other participants of blame, and there were plenty of naive investors who did rely on ratings, and I acknowledge that there were voices of caution that weren't heeded. But the idea that there was some overarching con (as opposed to a systemic screw-up with quite a few cons involved) ignores the fact that most of the supposed conners bought into the con themselves.

Posted by: GingerYellow | September 22, 2009 5:08 PM | Report abuse

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