December 5, 2008 Leave a comment
I've been a bad blogger. Busy time of year. Lots of stuff I've wanted to write about lately, but haven't had the time. The most important, though– the seemingly mundane (boring) subject of bond-rating agencies. Ever since I first started to understand this giant financial mess thanks to This American Life (still the best explanation), I've been somewhat surprised at how the hugely important role of the bond-rating agencies has been ignored in all this. Basically, various financial intersts were bundling together a lot of low-quality subprime mortgages and then the bond-rating agencies– whose job it is to assess the safety/reliability of various investments– was rating them AAA (the best rating) despite the fact that they were built on mortgages made to people who simply could not afford the homes they were buying. Amazing. It is complicated stuff, but the New York Times' Roger Lowenstein (who has a knack for explaining misunderstood, really important issues), lays out the case about as clearly as can be done, here. It is not an easy read, but it is an important one. Rather than take out the good clips or try and summarize it for you, I'm just going to go with Ezra Klein's analogy (which, certainly resonates with me):
As Lowenstein's article makes clear, the ratings agencies failed for
many reasons, not least because they were effectively gamed. But
there's also evidence that they are bedeviled by a fundamental
conflict-of-interest. They are paid by the very banks whose products
they rate. If a bank can't get good ratings from one agency, say
Moody's, it will leave them for another, like S&P. Moreover, banks
only pay if they get a rating they accept. They pay for the delivery of
the rating, not the analysis. Profits are dependent, in other words, on
giving banks (and other actors) ratings they can live with. It would be
like if teachers only got paid when we got a good grade, and we could
always go to another instructor if we weren't happy with the first.
Some students might still fail in that world, but grade inflation would
This whole mess could not have happened without people all througout our financial system making really stupid decisions (obviously, people on Wall Street are way overpaid), but the credit-rating agencies should be one of the fundamental safeguards and they simply are not.