Credit Agencies

I’ve heard it argued that we could get along without things like government inspections of food safety. After all, consumers would still want to know that their can of black beans contains black beans rather than poison. So bean sellers, in order to bolster consumer confidence in their brand, might pay firms that specialize in food certification services to inspect their plants and proclaim them okay or not. Wouldn’t the certification firms have a huge conflict of interest? Well, no, the theory goes. Certification would only be worthwhile to the bean seller if the certification firm had a very strong brand. And a certification firm could only maintain its strong brand by doing the certification job with integrity. Thus we march along the libertopia without all dying of botulism.

Of course, things don’t work like that. Except, it turns out that this basically is the system we use to rate the quality of bonds. But as a system it’s failed miserably:

Since the subprime mortgage troubles exploded into a full-blown financial crisis last year, the three top credit-rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — have faced a firestorm of criticism about whether their rosy ratings of mortgage securities generated billions of dollars in losses to investors who relied on them.

The agencies are supposed to help investors evaluate the risk of what they are buying. But some former employees and many investors say the agencies, which were paid far more to rate complicated mortgage-related securities than to assess more traditional debt, either underestimated the risk of mortgage debt or simply overlooked its danger so they could rake in large profits during the housing boom.

Relative to the hypothetical bean scenario in which this sort of thing works out, we seem to have had a few issues here. One, for this scheme to work, the rating agencies need to place a higher value on the long-term viability of their brand than on short-term profit opportunities. But of course we know that people are often short-sighted, and often heavily discount the future relative to the present. Relatedly, for the scheme to work we need the firms to be primarily concern with the long-term interests of the firms rather than the interests of the managers. But even if Moody’s, qua company, winds up taking a giant hit over this, it’s still not clear that Moody’s top executives won’t have come out ahead.

Last of course there’s the simple issue of limited options. If two of the ratings agencies had stayed on track but one had gone in for a lot of bad actions, then the one firm might have profited in the short-run but would be dead now. But instead all three went chasing the money, so nobody gains a competitive advantage.

All of which is a long-winded way of saying that it would make a lot of sense to try to develop a public agency that rates credit instruments. Wouldn’t stop anyone from relying on private sector ratings if they wanted to. Nor would it guarantee that the public agency would always get things right. But it would provide a check on some of the distortions that the current system produces.