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Fix the ratings agencies!

Annie Lowrey -- who, I'll remind you, is listed on my census form as "unmarried partner" -- has an article running through some of the various amendments that senators are hoping to make to Dodd's financial regulation bill. This caught my eye:

Fix the ratings agencies. The Dodd bill does little to fix the credit ratings agencies, whose profligate stamping of AAA ratings on collapsing subprime mortgage-backed securities helped to stoke the crisis. (The companies have a conflict of interest at the core of their business, in that they are paid by the companies whose securities they rate.) The Dodd bill creates a new office at the Securities and Exchange Commission to look closely at credit ratings agencies -- but does little more to further reform them. Numerous Democratic senators have cited the issue as a major weakness in the bill, and Senate staffers say it is unlikely to go unchanged. Sanders has said he will introduce new language to strengthen oversight over and regulation of the agencies.

Fixing the ratings agencies is actually quite easy: Right now, banks pay them to grade their products. That's a bit like if kids could pay teachers to grade their work -- and could choose a different teacher if they didn't like the grades. All you need to do is create a system where ratings agencies are randomly assigned, or assigned by a particular regulator, such that they no longer have the incentive to please the bank. The absence of this provision from the Dodd bill is inexplicable, and it should be quickly fixed when the bill hits the floor.

By Ezra Klein  |  April 27, 2010; 10:47 AM ET
Categories:  Financial Regulation  
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Comments

This should definitely be fixed. But seriously -- in a functional capitalistic marketplace, you shouldn't need the government to come in and require that ratings agencies be assigned randomly and have their ratings divorced from their own financial incentives. Shouldn't the private market have created such a system a long time ago, given that it's in everybody's (or at least most individuals and firms) interest to have good information? What was stopping them?

Posted by: vvf2 | April 27, 2010 11:00 AM | Report abuse

*****Shouldn't the private market have created such a system a long time ago, given that it's in everybody's (or at least most individuals and firms) interest to have good information? What was stopping them?*****

The most obvious answer is simply, it didn't occur to them. In other words, they thought they WERE getting good information.

But yes, conceptually, Ezra is correct: it shouldn't be hard to come up with a different version of the relationship between ratings agencies and sellers of investments. Politically, though, it's obvious no piece of cake, or else Dodd would have put this into the bill. What Ezra describes, although again, conceptually simple, would render the domestic ratings market something akin to a public utility, as the ratings firms would no longer be competing for business.

Posted by: Jasper999 | April 27, 2010 11:17 AM | Report abuse

Ezra when you interviewed Sen. Dodd, you did not ask him about that. Any explanation or simply missed out?

Is it the same way Dodd & Congress is missing that?

Posted by: umesh409 | April 27, 2010 11:33 AM | Report abuse

I think you are right Japser999. But the fact that it didn't ever occur to anyone in the business world (which runs, generally, on profit maximization) that the ratings agencies might be biased in their ratings process by their OWN profit maximization interests is a pretty sad commentary on the intelligence and naivete of the folks running these firms.

Posted by: vvf2 | April 27, 2010 11:34 AM | Report abuse

Are you from AAArkansas? Because you're the only AAA I saw.

Posted by: jeffwacker | April 27, 2010 11:36 AM | Report abuse

"All you need to do is create a system where ratings agencies are randomly assigned, or assigned by a particular regulator, such that they no longer have the incentive to please the bank. The absence of this provision from the Dodd bill is inexplicable, and it should be quickly fixed when the bill hits the floor."

The absence is inexplicable, and this bit, alone, would have helped mitigate, if not entirely prevent, the subprime housing crisis.

@vvf2: "is a pretty sad commentary on the intelligence and naivete of the folks running these firms"

Short-term thinking and perhaps willful ignorance (as there was a short-term incentive to display such ignorance). I don't think any of these people were so stupid as to think that hundreds of thousands of no-money-down, balloon and adjustable mortgages would do anything but inevitably lead to a rash of foreclosures. And they could not have believed the AAA ratings were justified.

What they could believe was that they got paid, and paid handsomely, today, for problems that would be "something-something-whatever" down the road and, anyway, they'd already bundled and sold all the mortgages, it was somebody else's problem now.

BTW, how the free market solves problems, unregulated, is organically. That means it is slow and messy. Eventually, the market would self-correct, finding certain models unsupportable for the long term health of the market and everybody involved. But how long would it take for the market to adjust accordingly? 50 years? 100 years? 1000 years? Why wait that long with a couple of systemic regulation that are proven to work could be put back in place, and a little more transparency would have kept the whole thing from getting so out of whack in the first place. Such as accurate ratings on the bundled securitized mortgages.

Posted by: Kevin_Willis | April 27, 2010 11:41 AM | Report abuse

"unmarried partner"
giggidy

Posted by: jfcarro | April 27, 2010 11:49 AM | Report abuse

Require the ratings agency to show their work -- post their models, the numbers that went in, and the sources for the inputs.

If investors find an agency's models unreliable, they will discount that agency's valuations; issuers will prefer agencies that investors find reliable. Transparency aligns incentives.


Posted by: Matt10019 | April 27, 2010 11:49 AM | Report abuse

*****a pretty sad commentary on the intelligence and naivete of the folks running these firms.*****

Not really. Although one or two firms went bust, for the most part big financial firms got bailed out by the government, and have returned to record profits, and the CXO level managers of these firms are as rich as ever. Heck, even a top level manager at Bear Sterns or Lehman probably isn't shedding many tears, given the fact that they were most likely all multi-millionaires by the time their respective firms went kaput.

It's not really a matter of naivete or stupidity. It's a matter of not caring, because you've already become a plutocrat, and your plutocratic status is safe (I mean, do you think Dimon or Blankfein are stupid enough to have all their wealth tied up in Chase or Goldman shares? I seriously doubt it).

I'm 110% certain a lot of these Wall Street fat cats strongly suspected the ratings agencies were peddling jive reports. But they just didn't care. Or, more accurately, they did care to the extent that they didn't want to upset the apple cart -- and so they were careful not to ask questions. As long as you've got plausible deniability on your side when the music finally stops, that's all that matters.

Posted by: Jasper999 | April 27, 2010 11:52 AM | Report abuse

Good points Kevin and Jasper. Well then, the logic proof is complete. We've come full circle to the original point. It's NOT a well-functioning market when the people running a company have no incentive to support the long-term sustainability of their company. This is why you can't use "Economics 101" theories of the market when it comes to so much of the business world. I was trying to give them the benefit of the doubt for the purpose of argument.

Posted by: vvf2 | April 27, 2010 12:12 PM | Report abuse

I'm 100% anti big government but rating agencies should absolutely unequivocally be government based entities. End of story.

This is like letting health insurance companies run their state's departments of insurance. Can't happen.

Posted by: visionbrkr | April 27, 2010 12:13 PM | Report abuse

I agree that rating agencies are fundamentally flawed, but the random assignment suggestion is flawed. If you randomly assign NRSRO's, you assume they're all perfect substitutes. They aren't. Would you randomly assign underwriters, auditors, and law firms to transactions as well? Moreover, the only incentive for the NRSRO is to retain the designation so as to keep getting assigned products, etc.... to rate. Even if an NRSRO gets discredited by bad ratings, they'll still be getting assigned work (and thus have a license to print money).

@Matt10019: Model disclosure is a double edged sword. Transparency allows manipulation to fit models. "But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings." (Dealbook Blog 4/24)

Posted by: dgs290 | April 27, 2010 12:49 PM | Report abuse

another good comparison is if they let doctors accept money, trips and bonuses etc from pharmaceutical companies in exchange for hawking their drug.

oh wait they still do that.

Posted by: visionbrkr | April 27, 2010 1:16 PM | Report abuse

@dgs90: Investors did not have easy access to the models you mention. If the model is public, and susceptible to improvement in a competitive environment, then adjusting deals to meet the model's standards strikes me as a good thing.

Posted by: Matt10019 | April 27, 2010 2:00 PM | Report abuse

"That's a bit like if kids could pay teachers to grade their work -- and could choose a different teacher if they didn't like the grades."

Oh -- so it's like college?

Posted by: clifton_ealy | April 27, 2010 3:27 PM | Report abuse

vvf2: "Shouldn't the private market have created such a system a long time ago, given that it's in everybody's (or at least most individuals and firms) interest to have good information?"

Seriously?

It is absolutely not in the best interest of any party for the opposing party to have good information. It is in the best interest to have the opposing party have poor information.

Posted by: dpurp | April 27, 2010 9:49 PM | Report abuse

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