Related to the last post, here's a question that's been bugging me: One of the key protections that failed was the bond rating agencies. Individual investors or managers knew little about the underlying assets. They knew the rating. And the ratings were wrong. As Roger Lowenstein writes:
You have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody's, then the investor could forget about the underlying mortgages. He wouldn't need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities.Over the last decade, Moody's and its two principal competitors, Standard & Poor's and Fitch, played this game to perfection — putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody's in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent...Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and Standard & Poor's that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.
As Lowenstein's article makes clear, the ratings agencies failed for many reasons, not least because they were effectively gamed. But there's also evidence that they are bedeviled by a fundamental conflict-of-interest. They are paid by the very banks whose products they rate. If a bank can't get good ratings from one agency, say Moody's, it will leave them for another, like S&P. Moreover, banks only pay if they get a rating they accept. They pay for the delivery of the rating, not the analysis. Profits are dependent, in other words, on giving banks (and other actors) ratings they can live with. It would be like if teachers only got paid when we got a good grade, and we could always go to another instructor if we weren't happy with the first. Some students might still fail in that world, but grade inflation would be rampant.So here's my question: Why should we have private ratings agencies at all, rather than outsourcing this to a public actor who's not bedeviled by the need to make a profit, like the Federal Reserve?
