There’s no doubt that the Big three bond-rating agencies—Moody’s, Standard & Poor’s, and Fitch—played a crucial role in the current financial crisis. If they hadn’t given favourable ratings to bonds that were securitized from subprime mortgages, the housing bubble wouldn’t have inflated to the levels that it did and banks wouldn’t have loaded up their balance sheets with now toxic assets.
This has led many to portray the ratings agencies as incompetent, corrupt and downright villainous. For the most part, this is a fair cop. They did a terrible job of accurately assessing the risk of mortgage backed securities. But on the key question—why did they do such a terrible job?—most of the analysis goes awry.
Probably the most popular explanation for the incompetence of ratings agencies is that the issuer pays fee structure corrupted the process. But as we’ve shown, government regulations created an investor demand for high ratings that likely would have resulted in exactly the same kind of ratings inflation.
Another popular explanation for the ratings debacle says that the ratings agencies simply became lazy and complacent thanks to the government created de facto oligopoly granted to Fitch, Moody’s and S&P. This is getting far closer to the truth. Numerous financial regulations basically gave the Big Three’s decisions the force of law and guaranteed them market-share. Under this circumstance, almost any company would be likely to produce poor quality products.
But the problem isn’t really that the people working at the Big Three were lazy or stupid. They were hard-working, smart people who were very often doing the best job they could. The problem was that the government protection of their businesses eliminated any external market checks that would have indicated to them that they were doing a poor job.
Let’s back up. In a competitive market place, different companies structure their enterprises according to different ideas. In a counter-factual world of openly competing credit advisors, each rating agency would have had to experiment with different theories about credit risk and adjust their theories according the market’s reaction. The process of competition would have worked to produce better ratings by putting the bad credit advisors out of business.
Now it’s very possible that errors in ratings would still happen, and bad ratings companies may even come to dominate for a time because the market mistakenly preferred the wrong rating theory. But a competitive market for ratings would have at least had a chance of producing a better result, and likely would have over the long term.
Isolated from the feedback of the market, the ratings agencies lacked an exogenous indicator about the quality of their ratings. They were left to guess whether or not they were employing the right system, like the socialist shoe maker who just has to guess how many shoes he makes because there’s no price system. Arguments about how to rate mortgage bonds were reduced to just that—arguments that could only be cognitively evaluated rather than tested in the marketplace.
In short, the very laws that protected the ratings agencies marketshare and guaranteed them business, also destroyed the competitive process that could have led to the discovery of better ways to evaluate bond risk. The agencies were victims of the regulatory framework, rendered blind to their own errors.
This is an important point because at least some people think the answer to the oligopoly of Fitch, S&P and Moody’s is to create a monopoly—a regulator charged with overseeing the adequateness of the procedures at the agencies. This would only compound the knowledge problems that led to the ratings debacle in the first place by further removing market tests for ratings theories. If you thought the oligopolist ratings were bad, just imagine how bad political ratings will be.
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