Question for Austrians - Credit rating agencies: a failure of private regulation?

6 posts

Bob Dylan Roof

This is a relatively facile analysis coming from a noob, but here is how I understand credit rating agencies.

As I understand it, agencies like Moody's supply solicited and unsolicited credit ratings to firms, with the latter method supposedly forcing companies to register with the agency or risk a credit downgrade. While this method provides banks with an incentive to pay for rating services, it doesn't bind them to a specific ratings agency. Thus, ratings agencies compete for business by offering more favorable ratings of a given target bank's securities. Since banks seem to heavily rely on ratings agencies to evaluate credit, there is a stark information asymmetry in favor of rating agencies and consequently a big incentive for agencies to provide inaccurate information in order to attract business. In addition, there is an incentive for banks to collude with ratings agencies to mark up their low-quality debt in order to artificially boost its value on the market. In practice, this translated into AAA-rated subprime security packages before the subprime crisis.

Ordinarily one would think that an agency would be liable for breach of contract, fraud, or some negligent tort for providing such blatantly inaccurate information. However, the credit ratings agencies have been immunized from suit by successfully claiming that their ratings are public opinion under the 1st Amendment. Is this a failure of the Market, or another example of government-protected fraud?

I'm not sure that banks rely heavily on the ratings agencies to evaluate credit. It could be true, but from what I can tell banks have their own staff and metrics for figuring out who is creditworthy. I'm not sure how this works. On the surface, the rating agencies seem like superfluous BS to me.

Information asymmetry is a problem in the market. There are various measures and solutions for this kind of thing.

As for breaking laws, I would have to side more with the claim that it is a first amendment right and they can't be sued for opinion. If they are telling flat-out lies that are of a more objective nature, then that is fraud. But this stance makes credit rating agencies almost worthless, as they should be. These agencies gave Fannie and Freddie their highest ratings because all the securities were backed by the government. When they (the securities held by these firms) weren't backed, the rating looked preposterous. This kind of thing is partially caused by an inability to predict due to regime uncertainty.

With a government that can bail out almost anyone and a cartel on credit creation through the central bank, how could any credit rating agency even semi-accurately predict the risk of default? I'm not sure that they can be accurate or effective. The claim that they can be probably sits in some legal gray area.

There might be incentive for them to do this, but I don't think this is the reason why they did it. The "economic fundamentals" as far as they could tell were perfect. I'm doubtful that the Bush administration expanded housing programs in order to help the credit rating agencies, but I could be wrong. The market crash in '08 surprised most everyone. Many of the banks that gave out bad loans and bought good credit ratings didn't stay in business or get bailed out. Not to say that cartelization has happened before, and I'm not saying there aren't any group-selfish psychopaths running a lot of the financial stuff, but to have not heard anything about this sort of thing makes it border on conspiracy theory.
Bob Dylan Roof
From what I've read in the non-technical mainstream media, private ratings dramatically affect investment banking, and the ratings agencies themselves pull in hundreds of millions in revenue. I know there is a great deal of political theater involved in the current downgrade, but I also understand that it will have real economic consequences.

This is sort of an aside, but is it easy for you to imagine private solutions to the information asymmetry problem?

The ratings they provide are more analogous to legal counsel than mere public opinion, don't you think? In the most extreme cases, they're acting for all intents and purposes as third party underwriters.

Is this the only reason? A senate report suggested that there was a great deal of direct collusion between banks and ratings agencies.

I didn't mean to imply that the socialist policies of the Bush administration had any direct connection to the credit rating agencies. I was referring to an incentive for banks and ratings agencies to conspire to misrepresent the value of certain securities.

According to the Senate report I mentioned above, "Moody’s Investors Service and Standard & Poor’s adjusted the way they graded securities after Goldman Sachs Group Inc., UBS AG and at least six more banks pressured them."
A meta-rating agency? That's all I got. I don't really know the nuances of the financial industry.

As for collusion, I don't deny that it happened at all. I just don't think that these deals are the sole cause of these kinds of problems, or that "everyone was in on it". Thanks for bringing that report to my attention.

Now I'm left wondering if this kind of thing has ever happened when there weren't gov't-backed securities (other than bonds)

This is why I consider this sort of thing to be a legal gray area. I'm not sure if it is like legal counsel or just an opinion. It looks to me like the goal of these firms are to act as underwriters.
Cadavre Exquis
Maybe at one point the ratings agencies did provide crucial information to markets, but this is probably just another example of successful rent-seeking. Now the consequences of a ratings downgrade have more to do with their influential position than the quality of their research, as far as I can see.

For example, Mutual Fund A's mandate may state that certain securities linked to govt bonds need to be sold off in the event of a downgrade. So A's managers are forced to sell off securities to avoid breaching fiduciary duties. Pension/retirement funds have especially stringent guidelines as to what securities may be held. Retail investors also use ratings as a rough guide to determine credit risk. All this equates to a ratings agency like S&P wielding enormous clout within the market, but without any fiduciary duty or duty of care owed to those most affected.

Is it possible to break up the ratings oligopoly? I doubt it. The market for ratings services seeks depth in an agency's capabilities - wider coverage means more information can be sold at a higher price, and larger firms dominate. The measure of success is not the quality of research/predictions.

Shouldn't such companies have methodology out in the open?