Ever since listening to the classic This American Life "Giant Pool of Money" (which I'm sure I've plugged here before), I've been certain that the failure of the bond-rating agencies has been the largely untold story of the financial crisis. The New Yorker's James Surowiecki makes an interesting argument that having the bond-rating agencies act with official government sanction creates a falls sense of security and that we would be much better off if these angencies weren't government sanctioned and protected:
The conventional explanation of what’s wrong with the rating agencies
focusses on the fact that most of them are paid by the very people
whose financial products they rate. That problem needs to be fixed, and
last week the S.E.C. proposed new rules to address conflicts of
interest. But there’s a much bigger problem, which is that, even though
nearly everyone knows that the agencies are compromised and exert too
much influence, the system makes it impossible not to rely on them. In
theory, of course, the mere fact that a rating agency says a particular
bond is AAA (close to risk-free) doesn’t mean that investors have to
buy it; the agencies’ opinions should be just one ingredient in any
decision. In practice, the government’s seal of approval, coupled with
those regulatory requirements, encourages investors to put far too much
weight on the ratings…
But we need a divorce: the rating agencies shouldn’t be
government-sanctioned and government-protected institutions and their
judgments shouldn’t be part of the rules that govern how investors can
act…Oddly, the ratings system, broken as it is,
remains attractive to many investors who have been burned by it. For
one thing, it provides an easily comprehensible standard: without it,
we’d need to come up with new ways of measuring risk. More insidiously,
the ratings system provides a ready-made excuse for failure: as long as
you’re buying AAA-rated assets, you can say you’re being responsible.
After the housing crash, though, we know how illusory those AAA ratings
can be. It’s time for investors to face reality: working with a fake
safety net is more dangerous than working without any net at all.
Not quite sure if this is the solution, but if we are going to address the problems with our financial system, we certainly needs some sort of substantial reform on the role of the bond-rating agencies.
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