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Could FinReg hurt the economy in the short term?

Greg Mankiw points to a Wall Street Journal report that credit ratings agencies are asking clients to stop using their ratings until they can figure out the legal exposure implied by the financial regulation bill's provision making them liable for the quality of their analysis. This has created some predictable problems in the bond markets, which rely heavily on those ratings.

This leads Mankiw to call the legislation the "Dodd-Frank anti-stimulus bill." Hyperbolic, but I'm not entirely unsympathetic. One of the difficulties in recovering from a financial crisis is that you need the market to be moving swiftly so businesses can get capital now and feel comfortable that they'll have access to capital later, but instead the major lenders are risk averse, the regulators are cracking down because they're ashamed of their previous failure, and the new rules are creating a lot of uncertainty and unintended consequences.

I don't know exactly what you do about this -- we did need a new financial regulation structure, and it's telling that the ratings agencies are freaking out about having to answer for the quality of their product -- but it's a plausible drag on growth in the coming months.

By Ezra Klein  |  July 22, 2010; 10:30 AM ET
Categories:  Financial Regulation  
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Comments

I'm sure the ratings agencies would love to get an exemption from accuracy, being "too important to fail", or "too important to be in anyway liable for how we rate market-destroying securities as AAA", and can make a nice argument, but they should be on the hook for accuracy, or the quality of their ratings should be considered to be very, very low.

We could have a program where ratings agencies opt out of liability for the accuracy of their ratings, with the understanding that that automatically makes their ratings "junk ratings". Then they get to choose!

Posted by: Kevin_Willis | July 22, 2010 10:35 AM | Report abuse

Unpredictability is a drag on economic growth. Given the unpredictability in economic decisions for businesses and individuals on issues such as financial regulation fallout; health care cost projections; energy costs; and most importantly income, capital gains, and estate tax increases starting in January 2011, this economy will not grow in any appreciable way for at least a couple years.

Barack Obama wanted to bring big change to Washington, but the necessary unpredictibility that comes with bring change will also bring the slow to no growth economic performance that will lead him to being a one term president.

Posted by: lancediverson | July 22, 2010 10:42 AM | Report abuse

One report today's Washington Post highlights such an unintended consequence. As a result of new financial regulations passed unilaterally by the Social-Democratic Party, many hard-working Americans with perfect credit ratings are less able to secure loans for food and shelter. The Post report states that "Now, frugal-minded consumers are charging less on their credit cards, paying down their balances and steering clear of penalty fees -- steps that are financially responsible but have the industry scrambling to find new ways to make money. [...] And one issuer even allegedly threatened to reject consumers with high credit scores because they didn't boost the bottom line."

Posted by: rmgregory | July 22, 2010 10:57 AM | Report abuse

Much like repealing the tax cuts it will hurt economic growth.

However, as is evident from the WSJ article, the government was subsidising the rating agencies business model by codifying the use of their product in fixed income prospectuses. On the other hand the rating could be completely wrong and the agency would not be held responsible.

It was a problem that needed to be fixed.

Posted by: chrisgaun | July 22, 2010 11:03 AM | Report abuse

Much like repealing the tax cuts it will hurt economic growth.

However, as is evident from the WSJ article, the government was subsidising the rating agencies business model by codifying the use of their product in fixed income prospectuses. On the other hand the rating could be completely wrong and the agency would not be held responsible.

It was a problem that needed to be fixed.

Posted by: chrisgaun | July 22, 2010 11:07 AM | Report abuse

After the crash we could have simply pumped that trillion dollars back into the banks, etc. and told them to go back to business as usual. Which might have worked, but at the expense of confidence in the future. Instead we screwed around for a couple of years and finally established some new parameters for doing financial business. Of course, there is uncertainty, but it should be offset with renewed confidence by the markets and consumers. Instead we've got a bunch of Nervous Nellies like Mankiw standing around with terror in their eyes and wringing their hands.

Posted by: adagio847 | July 22, 2010 11:19 AM | Report abuse

"However, as is evident from the WSJ article, the government was subsidising the rating agencies business model by codifying the use of their product in fixed income prospectuses."

This is exactly correct.

"On the other hand the rating could be completely wrong and the agency would not be held responsible.

It was a problem that needed to be fixed."

Or you could go the other direction, and rather than compound government intervention we just eliminate the original intervention.

Rating agencies used to be paid by lenders who wanted to have securities they were going to purchase rated. There was a strong incentive for the agencies not to screw up.

Then the government stepped in and required nationally recognized agencies for these mandatory ratings (kind of hard to become a 'nationally recognized agency' if ratings must come from the established guys).

So government intrusion nuked an efficient system, created perverse incentives and for that matter a cartel.

Instead of adding more layers of government intrusion with its attendant (forseeable and unforseable) side effects, just get rid of government involvement.

S&P won't have to balance itself between providing good ratings for customers and avoiding the occasional lawsuit and dealing with all sorts of tedious government regulation - it can focus on providing objective analysis for its buy side customers, and if it screws up too much it closes its doors.

Posted by: justin84 | July 22, 2010 11:31 AM | Report abuse

It's a cascade of unintended consequences from here on out. You ain't seen nuthin', yet.

Posted by: msoja | July 22, 2010 11:34 AM | Report abuse

@Kevin_Willis - "[T]hey should be on the hook for accuracy".

A "rating" is nothing but an opinion, Willis.

If ratings were left to the free market (they haven't been, for most of my life), then people who rely on ratings for their own livelihood would punish the incompetent and criminal, and reward those providing a superior product.

Government *cannot* take the guesswork out of ratings. Government *cannot* magically ferret out incompetence, laziness, bad luck or plain poor choices from the millions of business endeavors that interest raters. The whole supposition is the rankets of rank nonsense.

Posted by: msoja | July 22, 2010 11:44 AM | Report abuse

"rankest"

Posted by: msoja | July 22, 2010 11:45 AM | Report abuse

In other news, refraining from burning your house down in midwinter will make you colder for the time being.

Posted by: paul314 | July 22, 2010 11:54 AM | Report abuse

@rmgregory: And one issuer even allegedly threatened to reject consumers with high credit scores because they didn't boost the bottom line."

Nice trafficking in anonymous allegations.

That is why the big banks recorded record profits this quarter...



The easy solution to the strike (that's what it is, but no conservative will denounce it as they would a labor action) by the ratings agencies is fire them all the way Raygun fired PATCO and to establish a government credit rating system, that is not dependent on industry for its funding. That is the reason the ratings agencies sucked so badly. Their cash flow is dependent on their clients (the people with bonds to be rated) being happy not on the accuracy of their ratings because the buyers of bonds don't pay their bills, the issuers do.

There are always unintended consequences, but the ratings agencies taking their ball and going home is an easy one to solve.

"Party, many hard-working Americans with perfect credit ratings are less able to secure loans for food and shelter."

what total tripe. I continue to get credit card solicitations every day. And people with perfect credit generally are not borrowing money for necessities, as they are probably in relatively good financial health to qualify for a high credit score.

Posted by: srw3 | July 22, 2010 11:59 AM | Report abuse

@msoja
Or ... if ratings were left to the free market, people who rely on ratings for their own livelihood could lose their livelihood after being defrauded by ratings companies in cahoots with the businesses they're rating.

The free market cannot magically ferret out cheaters and thieves.

And, as for ratings being nothing but opinions, I'll be happy when I see that tagline: "Moody's. Nothing but opinions."

Ratings agencies want to play both sides; they claim to be reliable and yet unaccountable.

By definition, a superior product is more than "just an opinion." Otherwise, I'd quit my day job and sell my own credit ratings.

Posted by: dpurp | July 22, 2010 12:12 PM | Report abuse

@ezra:

These are not unintended consequences; they're entirely intended.

Yes, punishing an industry if it defrauds customers will slow the artificial (temporary) growth that would have occurred had unsuspecting customers continued to rely on that industry.

If agencies are unable to provide evidence that they're providing anything of value, then, yes, these are exactly the consequences that are expected.

This is a correction to the rate of growth.

Similarly, if a toy manufacturer is told it can no longer sell its popular "Li'l Chokeable Balls O' Lead" product, the resulting slower growth rate is completely intended.

Posted by: dpurp | July 22, 2010 12:26 PM | Report abuse

What good is a AAA rating if there are no consequences for those ratings being inaccurate? Isn't this one of the major reasons the MBSs and CDOs caused the leverage meltdown? People were relying on the ratings of the securities in the traunches to decide which were safer and which were riskier and those ratings ended up being mostly meaningless. The idea that we should go back to the ratings system that enabled the securities meltdown is insane, ie doing the same thing and expecting different results. What is rmg's, sbj2's, or msoja's solutions for fixing the bond ratings agencies? All I hear is whining about the current law.

Posted by: srw3 | July 22, 2010 12:30 PM | Report abuse

Justin84::"Rating agencies used to be paid by lenders who wanted to have securities they were going to purchase rated. There was a strong incentive for the agencies not to screw up."

They were and are paid by the issuers, not the investors. Also, the business was effectively a cartel of S&P/Moodys/Fitch long before the NRSRO rules came into being.

Posted by: tomjf | July 22, 2010 1:19 PM | Report abuse

You know, every time safety regulations are imposed, the industry in question whines and bleats about "hurting growth". But really, what kind of "growth" is being hurt?

The unregulated market posts nice profits, as long as it lasts. And then it crashes.

Posted by: rick_desper | July 22, 2010 1:32 PM | Report abuse

"There are always unintended consequences, but the ratings agencies taking their ball and going home is an easy one to solve....That is the reason the ratings agencies sucked so badly. Their cash flow is dependent on their clients (the people with bonds to be rated) being happy not on the accuracy of their ratings because the buyers of bonds don't pay their bills, the issuers do."

Srw3, I agree. There are several ratings agencies which have basically been granted cartel privileges as Nationally Recognized Statistical Rating Organizations.

Eliminate the cartel, and don't make ratings mandatory.

Let buyers of securities ask to have those securities rated if they are willing to pay for it. If buyers are screwed (either by fraud or incompetence) the raters who screwed them will suffer accordingly and close their doors. Also, if ratings aren't mandatory an agency can issue 'unable to rate' as a rating which would have been valuable information a few years ago.

Then again, a firm like Moody's might have still gone hog wild with AAA designations under free market conditions, but it wouldn't be threatened with the harsh punishment of "slower growth" per dpurp's comment - it would have outright failed.

"The free market cannot magically ferret out cheaters and thieves... And, as for ratings being nothing but opinions, I'll be happy when I see that tagline: "Moody's. Nothing but opinions."

Dpurp, the freemarket isn't magic, but it is far harsher when it finds cheaters and thieves. The government finds cheaters and thieves and threatens to cut the growth rate of their business. Maybe a token fine or fee. The free market sues cheaters for fraud and denies business to the incompetent.

By the way, I think you'll find this link quite entertaining:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQzRB3sWOivE

"What good is a AAA rating if there are no consequences for those ratings being inaccurate? Isn't this one of the major reasons the MBSs and CDOs caused the leverage meltdown? People were relying on the ratings of the securities in the traunches to decide which were safer and which were riskier and those ratings ended up being mostly meaningless. The idea that we should go back to the ratings system that enabled the securities meltdown is insane, ie doing the same thing and expecting different results. What is rmg's, sbj2's, or msoja's solutions for fixing the bond ratings agencies? All I hear is whining about the current law."

Srw3, the solution for bad AAA ratings is that said rating agency will have a difficult time finding buyers. Today, Moody's is still getting a lot of business, and will continue to get a lot of business under FinReg.

Posted by: justin84 | July 22, 2010 1:39 PM | Report abuse

"They were and are paid by the issuers, not the investors. Also, the business was effectively a cartel of S&P/Moodys/Fitch long before the NRSRO rules came into being."

Thanks for this. Beyond which, cartels are usually pretty efficient. So, it seems highly implausible that the government would have both created a cartel and introduced inefficiency simultaneously. Except for the obvious fact that the government is a magical destroyer of all things and the only place on earth where matter and anti-matter have joined forces, of course.

Posted by: slag | July 22, 2010 1:43 PM | Report abuse

tomjf,

"They were and are paid by the issuers, not the investors."

Were rating agencies always paid by the issuers? Let's look.

"The economic turbulence of the 1970s raised the industry's profile again. In 1975, the Securities and Exchange Commission (SEC) deemed certain firms "nationally recognized statistical ratings organizations"--making a sign-off from a ratings agency a necessity for anyone selling debt. But ratings also became a stamp of actuarial approval that often let investors and regulators skimp on their own due diligence.

Meanwhile, the agencies' business model morphed from one in which investors paid for ratings to one in which bond issuers did. That generated more revenue, but it also created a massive conflict of interest, often cited in the current mortgage mess."

http://www.time.com/time/magazine/article/0,9171,1886559,00.html

"...with the SEC even going so far in 1973 to designate certain rating agencies as Nationally Recognized Statistical Ratings Organizations. Interestingly, it was around this time that the agencies shifted to the practice of charging issuers for ratings and earning most of their revenues from such charges."

http://www1.worldbank.org/finance/assets/images/Historical_Primer.pdf

I'm not sure whether the actual designation was in 1973 or 1975, but I presume that Time and the World Bank have the basic story right.

To the extent that any one would prefer a rating paid by the issuer rather than the buyer in a free market, then that is their choice. I'd expect under a free market system any divergence from a buyer pays to issuer pays system would be short lived (certainly it would be gone today).

"Also, the business was effectively a cartel of S&P/Moodys/Fitch long before the NRSRO rules came into being."

They may have been large and important market players, but this misses the point.

You can be a large and important market player, but still have to keep up your competitive game or risk being taken out by the new guy.

It's hard enough competing with an established name brand - but its much harder when the government says your service must be provided by one of your competitors. This is the change that turns monopolistic competition (in the economic sense of the term) into outright cartel.

In any case, it's hard to avoid the conclusion that a lot of the problems with the ratings agencies are related to regulations from the 1970s which changed how the industry operated.

Posted by: justin84 | July 22, 2010 2:10 PM | Report abuse

"I don't know exactly what you do about this -- we did need a new financial regulation structure, and it's telling that the ratings agencies are freaking out about having to answer for the quality of their product -- but it's a plausible drag on growth in the coming months."

What you do is have the new regulations take effect some defined time after the bill is signed, not the day after. If there was a built in 6 month delay, this probably would have been a non-issue.

I find that Meredith Whitney has still provided the most accurate assessment of the situation:

"Regulators should be mindful that regulatory change during the midst of a credit crisis often ends with unintended consequences. Those same consumers that regulators are trying to help are actually being hurt by a vast reduction in available credit.

Main Street represents the foundation of this country. Reviving it should take priority over any regulatory reform or systemic overhaul."

http://online.wsj.com/article/SB10001424052748704471504574445470989162030.html

Double dip here we come.

Posted by: jnc4p | July 22, 2010 3:07 PM | Report abuse

Unintended consequences? Are you kidding? Are you kidding? (quoting Pelosi) This is the very first time I have heard Klein acknowledge that there is such a thing. Usually he presents our vast and complex society as something like a lego structure, that "smart" (his favorite attribute of himself) people can take apart and reconstruct. Easy. no problem. Like American medicine, with its millions of daily transactions. Take it apart and rebuild from the ground up, changing every single medical act and transaction? no problemo.

Posted by: truck1 | July 22, 2010 3:57 PM | Report abuse

So the ratings agencies can downgrade everything by one alphabetical letter, and they will be covered. And probably more accurate! Competition, anyone?

Posted by: Lee_A_Arnold | July 22, 2010 5:20 PM | Report abuse

I agree, the new market regulations will result in some timidity - that's for sure. Such is the case with any drastic change However, our goal should not be to shoot right out from this debacle and continue as we always have: essentially flying by the seat of our pants. It may hurt, but reformed, deliberate growth is the right answer. Personally, I'm looking forward to making investments based on reliable ratings and with banks whose risk takers know common-sense boundaries. I expand on this view in my recent post on Paul Volcker and the Volcker rule on www.thecorporateobserver.com

Posted by: zach6 | July 23, 2010 4:48 PM | Report abuse

I agree, the new market regulations will result in some timidity - that's for sure. Such is the case with any drastic change However, our goal should not be to shoot right out from this debacle and continue as we always have: essentially flying by the seat of our pants. It may hurt, but reformed, deliberate growth is the right answer. Personally, I'm looking forward to making investments based on reliable ratings and with banks whose risk takers know common-sense boundaries. I expand on this view in my recent post on Paul Volcker and the Volcker rule on www.thecorporateobserver.com

Posted by: zach6 | July 23, 2010 4:49 PM | Report abuse

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