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How competition brought down Wall Street, and what it did to the rest of us

"How did increased competition affect credit ratings?" by Bo Becker and Todd Milbourn:

The credit rating industry has historically been dominated by just two agencies, Moody’s and S&P, leading to longstanding legislative and regulatory calls for increased competition. The material entry of a third rating agency (Fitch) to the competitive landscape offers a unique experiment to empirically examine how in fact increased competition affects the credit ratings market. Increased competition from Fitch coincides with lower quality ratings from the incumbents: rating levels went up, the correlation between ratings and market-implied yields fell, and the ability of ratings to predict default deteriorated. We offer several possible explanations for these findings that are linked to existing theories.

"Effects of the Financial Crisis and Great Recession on American Households," by Michael D. Hurd and Susann Rohwedder:

We find that the effects of the recession are widespread: between November 2008 and April 2010 about 39 percent of households had either been unemployed, had negative equity in their house or had been in arrears in their house payments. Reductions in spending were common especially following unemployment. On average expectations about stock market prices and housing prices are pessimistic, particularly long-run expectations. Among workers, expectations about becoming unemployed have recovered somewhat from their low point in May 2009 but still remain high. Overall the data suggest that households are not optimistic about their economic futures.

By Ezra Klein  | October 4, 2010; 11:31 AM ET
Categories:  Economics  
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Comments

Keep in mind that the rating agencies were paid by issuers to help "market" the securities they were selling, not by the people relying on them for accuracy when determining what securities to buy. From that perspective, competition worked. It reduced the costs for the issuers of the securities. The buyers didn't pay anything for the ratings, and they got what they paid for.

There's also the issue of the entry restrictions into the market due to the NRSRO requirements.

http://en.wikipedia.org/wiki/Nationally_Recognized_Statistical_Rating_Organization

As an example of "free market failure" this one has some holes.

Posted by: jnc4p | October 4, 2010 12:03 PM | Report abuse

Jnc4p has it exactly correct here.

Mysterious failures of competition are usually a symptom of government messing with the normal operations of the market.

Competition didn't bring down Wall Street, the government created perverse incentives in the market for rating securities and that (is one of the things which) brought down Wall Street.

To your credit, in a previous post you discovered the correct solution - get government out of the business entirely.

That being said, your typical reader is likely to come away with "gee, competition led to worse outcomes, market failure, we need more government involvement" after reading this post.

"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."

http://voices.washingtonpost.com/ezra-klein/2010/05/explaining_finreg_the_rating_a.html

Posted by: justin84 | October 4, 2010 1:09 PM | Report abuse

http://www.hbs.edu/research/pdf/09-051.pdf

working paper of competition and ratings agencies

Posted by: bdballard | October 4, 2010 1:50 PM | Report abuse

just to clarify, the proposition being examined in the ratings agency paper is something like:

"In particular, there is a broad consensus among policy
makers and regulators around the potential benefits of increasing competition between ratings
providers as a tool for improving ratings quality. For example, Paul Schott Stevens, the President of
the Investment Company Institute, stated “I firmly believe that robust competition for the credit
rating industry is the best way to promote the continued integrity and reliability of their ratings” in
testimony for a US Senate Committee on Banking, Housing, and Urban Affairs. The empirical
merits of this push for competition are not at all well established, and because of the informationally
opaque setting, the theoretical predictions are ambiguous as well.
In this paper, we wish to examine the effect of increased competition in the ratings industry
and shed some light on the issue of whether or not it tends to improve the quality of ratings."

In fairness, this is not the proposition that jnc4p speaks of.

Posted by: bdballard | October 4, 2010 1:57 PM | Report abuse

@bdballard

"In fairness, this is not the proposition that jnc4p speaks of. "

No, but I would argue that adding more members to a cartel doesn't improve "competition", therefore the premise of the study is flawed.

One more member in OPEC doesn't make it any less likely to focus on benefiting producers rather than consumers of oil.

The real issue is whether or not you can increase "competition" by allowing a new rating agency with a different business model or if existing SEC regulations pretty much prevent it. See the linked Wikipedia article..

Posted by: jnc4p | October 4, 2010 2:12 PM | Report abuse

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