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Explaining FinReg: The rating agencies

moodysboard.JPG

Imagine a school with three teachers. But this isn't a public school. It's a private school testing out an innovative new funding system: The kids write the tests, fill them out and then pay the teachers to grade them. If they don't like the grade they get, they don't have to go back to that teacher.

Sound good?

That's not how we run schools, of course. But it is how we run Wall Street. The three major ratings agencies -- Standard & Poor's, Moody's and Fitch -- are paid by banks to grade (or "rate") their products. The problem here isn't just theoretical: One internal e-mail from Standard & Poor's saw an employee taking a group of analysts to task for their ratings. “We are meeting with your group this week to discuss adjusting criteria for rating C.D.O.s of real estate assets this week because of the ongoing threat of losing deals,” the e-mail said.

So why does anyone use these ratings? Two reasons: First, investors need some way of evaluating financial products that they don't have the time or resources to test on their own. Maybe it shouldn't be that way, but it is. Second, a variety of laws and regulations makes the ratings necessary. Under Basel II (a set of international regulations), for instance, banks can take on more leverage if they hold assets with AAA ratings. Other laws tell mutual funds and pension plans that they have to hold a certain amount of AAA securities.

In fact, the government actually credentials the rating agencies. So Standard & Poor's, Moody's and Fitch aren't just companies; they're "Nationally Recognized Statistical Rating Organizations." They've been blessed by the Feds.

The Dodd bill doesn't do a lot on rating agencies. It doesn't change their status or their business. A proposed amendment from Al Franken, Chuck Schumer and Bill Nelson would get at the conflict of interest by setting up a new agency that would decide which raters got to look at which securities. That way, there wouldn't be a financial incentive for the rating agencies to please the banks. On the other hand, this could create a sclerotic industry that banks find even easier to game.

So you probably need to go further. If you want to keep the laws using ratings in place, you need to bring the agencies much further into the public fold. I'd go so far as to say you should have a public agency rating securities and then private agencies offering second opinions. If the idea of AAA is that we want to sanction low-risk products for public policy, let's give the responsibility to someone who has the incentive to be conservative in handing the rating out and whose first responsibility is to the relevant policy objections.

But better than that would be to go in the other direction and get rid of the public credentialing entirely. These organizations are not, and never will be, infallible. So putting them on a pedestal is dangerous. It allows bankers to confidently trade products they don't understand. The letters AAA substitute for "buyer beware." But buyers should be wary of both financial products and ratings. And a more competitive market for ratings that doesn't have the government's blessing will move us toward both goals.

For more on rating agencies: See Mike Konczal's interview with a former director of Moody's; Matt Yglesias's primer; or this paper by Lawrence White.

For more from the Explaining FinReg series: Head here.

Photo credit: Fred Prouser/Reuters

By Ezra Klein  |  May 6, 2010; 3:00 PM ET
Categories:  Explaining financial regulation  
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Comments

"setting up a new agency that would decide which raters got to look at which securities. That way, there wouldn't be a financial incentive for the rating agencies to please the banks. On the other hand, this could create a sclerotic industry that banks find even easier to game."

"I'd go so far as to say you should have a public agency rating securities"

Please reconcile these 2 comments, i.e., why wouldn't the "public agency" be sclerotic?

Posted by: ostap666 | May 6, 2010 3:20 PM | Report abuse

Meanwhile, markets suddenly slide 1000 points (Dow).

Why do I think that this is the 'traders' (you know who they are) sending a little message to the legislature in Germany: "pay up to cover our bad bets," and to the legislature in Washington: "hands off our cash cows"?

Why do I think that the traders have also prepared before sending this demonstrative message, by establishing masses of high-leverage instruments that will reap them a few billion from driving down the markets (which they are in a position to do because of their millisecond-accurate control over the demand and supply of stocks and options)?

Why do I wonder when legislators everywhere are going to get tired of being bought off. Being bought off can be very very pleasant, to be sure...but politicians like power, and these events suggest that power is slipping out of their hands like sand. They might just wake up...but probably won't.

Posted by: PQuincy | May 6, 2010 3:24 PM | Report abuse

It's conventional wisdom that the conflict of interest renders rating agency outputs suspect. But can someone tell me why we ever see poor ratings? Is it all a blackmail game? In Ezra's analogy, do the teachers threaten to give a bad grade if a student doesn't cough up the cash? And make sure to do it every now and then to make the threat credible? (And wouldn't that require a cartel among rating agencies?)

Or to be more topical, Moody's is threatening to downgrade Greece's rating (no, duh). But is that because Greece has fallen behind in its payments and this is a shakedown?

Maybe small financial firms that don't provide the agencies much revenue get the bad scores. Sounds like an empirical question: true or not?

This conflict of interest thing sounds very plausible, I guess, but does it accord with reality in any meaningful way?

Or here's an alternative theory: rating agencies confirm the conventional wisdom. They don't know much about these products either but if everyone else is excited about them, then they just go along with the flow and give them their stamp of approval. Sort of like the Fed hesitating to pop a bubble when everyone's having so much fun. Or maybe it's a bit different. Maybe rating agencies are good at producing relative ratings within a narrow framework -- they can tell you if Company A's product is better or worse than a similar product from Company B -- but they don't have a clue about larger systemic risks: synthetic CDOs are just a bad idea during a housing bubble, no matter that Goldman's is a bit better than Lehman's.

Posted by: robbins2 | May 6, 2010 4:03 PM | Report abuse

well oligopoly in credit rating agencies actually help increase reputation costs: having fully competative ratings would likely exacerbate the issuer pays system by giving incentives for small players to swing for the fences even more than our current status.

keep in mind that we used to have a buyer pays system with it's own problems. some lawyers/economists have been thinking hard about hybrids...

Posted by: stantheman21 | May 6, 2010 4:50 PM | Report abuse

RatAgs.

They're called RatAgs.

Posted by: pj_camp | May 6, 2010 4:50 PM | Report abuse

How are products rated in other major non-U.S. financial markets like London, Tokyo, and etc.? Have they figured out a way around the conflicts of interests? Or a better way to have credible ratings?

There might be value in a hybrid approach, wherein anything that is to be rated AAA must be reviewed by a public agency or perhaps another one of the rating agencies. In other words, if the investment is supposedly risk free, give it another look.

Posted by: meander510 | May 6, 2010 4:58 PM | Report abuse

How are products rated in other major non-U.S. financial markets like London, Tokyo, and etc.? Have they figured out a way around the conflicts of interests? Or a better way to have credible ratings?

There might be value in a hybrid approach, wherein anything that is to be rated AAA must be reviewed by a public agency or perhaps another one of the rating agencies. In other words, if the investment is supposedly risk free, give it another look.

Posted by: meander510 | May 6, 2010 4:59 PM | Report abuse

pj_camp, nice.

Posted by: dpurp | May 6, 2010 9:27 PM | Report abuse

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