The Ratings Agency Problem

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Perusing Michael Spence’s The Next Convergence: The Future of Economic Growth in a Multispeed World yesterday, I was struck by this offhand remark about the origins of the financial crisis:

The problem in the period leading up to the crisis was that this portion of the financial system was only lightly or ineffectively regulated. Packages of loans were rated improperly, in part because of incentive problems: the originators and securitizers paid the rating agencies. Another aspect was complexity. The rating agencies didn’t understand the products and their risk characteristics. The combination of complexity and adverse incentives turned out to be toxic in the extreme.

This story seems to me to sell the free market short. A firm that’s in the business of producing ratings for debt instruments has very strong incentives not to rate things it doesn’t understand properly or let the question of who pays influence its ratings. It’s entire credibility and the viability of its whole business is on the line. A ratings agency that said things were safe that turned out to go bust at a huge rate would lose its market position and vanish off the face of the earth. Right? Right?

Well, no, as you can see in “Europe Faces Tough Road on Effort to Ease Greek Debt”:

Europe turns from its latest short-term fix for Greece to planning a longer-term bailout for the debt-plagued country, the ratings agency Standard & Poor’s indicated Monday how difficult it would be to offload some of the cost of rescuing Greece onto creditors without also provoking a default that could shock the global economy. […] But S.& P., responding to a French proposal to have banks give Athens more time to repay loans as they come due, seemed to leave little room for maneuver. The proposal would amount to a default, S.&P. said, because creditors would have to wait longer to be repaid and the value of Greek bonds would effectively be reduced.

The upshot here is that if S&P deems a given resolution of the Greek issue to constitute a “default,” then that triggers a bunch of other consequences. How much money the holders of Greek bonds get has real-world consequences. But how ratings agencies score the plan has other consequences, over and above those consequences. The ratings agencies, in other words, are not only still in business their whims need to be taken seriously in national capitals. Firms, municipalities, and even some of the smaller states are still largely at their mercy. They continue to drive headlines, as in “Moody’s Sees Much Bigger Local Debt in China” and in general continue to be some of the most important firms in the world. It’s a system that seems to me to be broken in a more profound way than anything as simple as a conflict of interest here or a failure to understand there.