On rating risk

In discussions of the subprime mortgage crisis and the CDS crisis which grew out of it, a lot is made of the failure of federal regulators, and a bit is made of the failure of securities rating firms (who blew it by giving disastrously risky products very safe ratings). The latter failure is often excused on the basis that there wasn't enough background data to accurately model the risks of these new products, though it is rightly noted that the firms had a financial interest in turning a blind eye to any data which would have led them to produce less rosy estimates of risk. Similar conflicts of interest destroyed Arthur Anderson after that firm failed to exercise proper oversight of deals being cut by Enron.

The SEC and a Senate committee are both digging into the matter, and new regulations limit those conflicts of interest. In announcing those new regulations though, the SEC was cautious, noting that "the rules fell short of what is needed to foster competition for Moody’s, S&P and Fitch. [SEC Commissioner Kathleen Casey] said the SEC must remove references to ratings from its own rules, such as requirements that money managers hold highly ranked securities, to discourage investor dependence." That dependence is common in private contracts as well, with companies requiring that their pension providers (for instance) must buy securities rated AAA or higher by one of those firms. But there's a way to avoid that problem, and to simultaneously solve the first two problems. Nationalize at least one of the firms.

Moody's is worth about half what it was when the Big Shitpile started collapsing. McGraw-Hill, owner of Standard & Poors, is similarly depressed. When lawsuits and subpoenas start flying around, they'll get even worse. In exchange for a bailout, the feds should simply take ownership of one of those companies' ratings divisions. It would operate as a government-backed corporation, in the vein of Amtrak or the Postal Service. Other firms could continue providing ratings for a fee, but the federal ratings would be funded by a small hike in the capital gains tax and by closing a stupid loophole that lets hedge fund managers pay miniscule taxes.

There would still be competition for the ratings, and people with private contracts could choose to rely on ratings by a private rating firm. But contracts which rely on ratings by the nationalized rating agency would still be valid (since the entity would still exist in some form), and the conflict of interest inherent in a privately-owned rating agency would be eliminated. And because the public owns the agency, there would be an incentive for raters who couldn't accurately model a security to default to giving it a very low rating, or to refuse to rate such securities altogether, until reliable data on its behavior becomes available.

There are surely many downsides to this, but I suspect that they are much smaller than the problems solved by the measure. This strikes me as a role supremely well suited for federal intervention, and astonishingly poorly suited for private industry. Taking one or more of the ratings firms truly public wouldn't necessarily do much to resolve the current crisis, but it would do a lot to stop the next one.

Update: See also Josh Marshall's comments on the rating firms.

More like this

Last December, I called for nationalizing the securities ratings firms, companies that propped up Big Shitpile through its heyday and actively encouraged the idiotic and destructive practices which brought us to the current economic crisis. Barry Ritholz reveals that the rating agencies may just…
There's been a lot of excellent posts debunking Standard & Poor's recent downgrade of U.S. debt on the merits--it is poor assessment of risk. Yes, there are substantive economic arguments against S&P's evaluation. But S&P is also fundamentally corrupt. The Coalition of the Sane must…
Monday, I wrote about how Standard & Poor's (S&P) downgrade of U.S. debt had political motivations--avoiding fraud investigations as well as 'convincing' the Securities and Exchange Commission to remove new regulations that could undercut their business: ...I won't rule out that S&P is…
One of the most frustrating things about the Standard and Poor's (S&P) U.S. debt downgrade is that S&P is part of the problem, as I've described before. They really aren't studious evaluators of evidence, untouched by the profit motive or ideology. They are venal hacks, as Matt Stoller…

"...blew it by giving disastrously risky products very safe ratings). The latter failure is often excused on the basis that there wasn't enough background data to accurately model the risks of these new products..."

Call me silly...but if I don't have sufficient data to decide how risky something is, I'm not going to just say "Oh, well, if I don't have any information, then it must be totally safe!" I mean, really. Imagine if the same mentality applied to the drug approval process! What is wrong with these people? (rhetorical question...)