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Home Publications Blogs Beat the Press Krugman Nails the Issue on Credit Rating Agencies

Krugman Nails the Issue on Credit Rating Agencies

Monday, 26 April 2010 03:02

A big part of the story of the housing bubble is that the bond rating agencies were willing to give issuers of mortgage-backed securities collaterized debt obligations investment grade ratings even when they were clearly junk. The explanation was that the rating agencies were being paid by the issuers, therefore they had an enormous incentive to bend their ratings. If they rated these issues honestly, they would lose their business.

The conflict of interest in this "issuer pays" system has been widely noted. Unfortunately it has prompted mostly strange genuflecting rather than serious thinking. The obvious way to fix the conflict is to take away the hiring decision from the issuer. The issuer would still pay the rating agency but a neutral party -- the SEC, the stock exchange on which the company is listed, the local baseball team -- would make the decision as to which agency gets hired.

Some of us have been pushing this one for a while (e.g. here and also Plunder and Blunder), but Congress has preferred much more complex regulations that would have no impact on the basic conflict of interest. However, Paul Krugman comes to the rescue in his column today. Maybe now someone in Congress will be able to think clearly on this issue.

Comments (14)Add Comment
written by izzatzo, April 26, 2010 9:35
Hello, you have reached Rubin Cubin Ratings.

If you would like a Perfect Storm Rating, please press "1" now.

If you would like a Who Could Have Known Rating, please press "2" now.

If you would like a Too Big to Fail Rating, please press "3" now.

If you would like a God's Work Rating, please press "0" really hard and fast and look up into the sky until an operator descends for assistance.
make them liable.
written by scott, April 26, 2010 9:39
Perhaps the easiest way to regulate them would be to professionalize the ratings agencies. Make them liable for due diligence and fiduciary duties to those who use their ratings for guidance. Once these ratings agencies have to get and maintain E&O insurance they will have an independent incentive to make accurate, diligent assessments.
bond ratings conflicts
written by David Cay Johnston, April 26, 2010 9:41
from the Annals of How Technological Advances Create Problems:

We could just ban photocopy machines, since the Xerox 941 was the source of this problem almost five decades ago. Until it came along bond buyers paid for ratings, but the dishonesty of bond buyers who used the photocopier to distribute information to people who had not paid for it killed this virtuous and self-reinforcing model.

This prompted the ratings agencies (except one new one, Egan-Jones) to solicit issuers for fees, resulting in the dishonest, disreputable system we have today that serves as a model of economic pollution since it hurt many people who never bought a bond or, for the matter, took out a mortgage.

We need a new way to make it in the interests of bond buyers (and marketers) to pay for flint-eyed ratings. Having the SEC pick the rater may not be optimal, but in no event should issuers pay for ratings, even indirectly.
Transparency has a role
written by leo, April 26, 2010 11:23
"even when they were clearly junk"

That's good but part of the bamboozle was to make nothing clear about nothing.
written by skeptonomist, April 26, 2010 12:12
The local baseball team may or may not be neutral but the exchanges probably are not. Stock exchanges would prefer to have the bonds of the companies they list rate higher rather than lower. Would the SEC choose rating companies by rolling dice? If not they will be susceptible to influence, if the decision is made casually at a high level. If the rating companies are evaluated in depth by the SEC, this introduces another layer of "bureaucracy", and the investigation of rating companies would probably have to involve at least partial duplicating of the ratings process.

If the ratings are entrusted to some arm of the finance industry, the ratings will most likely be biased in favor of the finance industry. Rather than face up to this and have ratings done in the simplest way, by the government, US economists will go through extraordinary contortions to preserve a "free market" which has never existed.
written by JBG, April 26, 2010 12:44
Johnston's comment is exceedingly helpful. He said that historically the procedure was done right -- bond buyers paid for ratings. So we need to think of a viable way to get back to that.

Pension funds must buy a lot of bonds and other securities. Perhaps a national consortium of pension funds could set up or otherwise acquire a rating agency of their own. Required would be that *all* pension funds over a certain size participate.

Other buyers could free ride by watching what the pension funds do. But probably the funds would not care, since they'd get the information first. Even if other rating agencies continued in the present fashion, the existence of ONE agency that produced honest ratings should be a strong influence toward keep the others honest.
written by Ron Alley, April 26, 2010 3:16
Scott has a point. We cannot expect careful and honest work from the ratings agencies unless we find a way to hold them accountable for their work. The simplest and most effective way is to permit those who rely on the work of ratings agencies (i.e. the investors) to sue the ratings agencies when they have been deceived by shoddy reports. Neither Baker nor Krugman deal effectively with the accountability piece.
written by Queen of Sheba, April 26, 2010 3:23
There is no reason why this should be complicated or expensive. Leo has the right idea - assign the task of choosing a ratings agency for a particular issue to the new consumer financial protection agency and have one person responsible for throwing a die or drawing a number out of a hat for assigning the rating agency. This die-throwing, or drawing, should be done by an employee who knows zero about the bond business or the ratings agencies (the janitor, maybe) and who stands to gain nothing regardless of the outcome of the draw.
written by erichwwk, April 26, 2010 4:13
The bigger story is why the credit agencies have not been held to account ALREADY.

Answering THAT question will go a long way to understanding the uphill struggle in countering the political power of the financial elite banksters.

For a long, detailed account try [url= http://www.nakedcapitalism.com...alism.com/ Yves Smiths's:

[url= [ http://www.amazon.com/s?ie=UTF...ch]ECONed: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism

Also of interest may be the George Akerlof, Paul Romer 1993 paper: Looting: The Economic Underworld of Bankruptcy for Profit ]http://www.scribd.com/doc/13579076/Looting-Akerlof-Romerl]Looting: The Economic Underworld of Bankruptcy for Profit "
written by erichwwk, April 26, 2010 4:31
Hmm.... One URL worked semi-properly.

so here's another worthy read at new deal 2.0:

http://www.newdeal20.org/2010/...an Scandal

by Eliot Spitzer and William Black

Monday, 04/26/2010 - 6:37 am
As Upton Sinclair said,
written by Scott ffolliott, April 26, 2010 11:31
As Upton Sinclair said, “It is difficult to get a man to understand something when his salary depends on his not understanding it.”
written by skeptonomist, April 27, 2010 9:19
Individual bond buyers are not going to pay for publicly-available ratings if they can help it - let somebody else pay. To get the buyers to pay would require some sort of mandatory participation which would have to be enforced by - the government. There would either have to be an arbitrary volume threshhold for requiring payment or there would have to be some sort of tax on every transaction, and the payment to the raters would come through the tax collector which would either be the exchange or the government. The exchange, again, has an interest in favorable ratings.

The problem is being approached through an irrational commitment to "free-market" ideology and a presumption that government involvement is always bad.
written by scott, April 27, 2010 9:23
How is it that professionals like David Cay and Dr. Baker don't understand professional markets? All (real) professions (of consequence) can be sued, carry E&O and have fiduciary duties.

Professors are professionals though they have almost no fiduciary duties. That is why they don't know how these markets work. The Chicago school has different reasons for ignoring this school (they have to create the free lunch for themselves.)

Under fiduciary laws if you give advice that you believe or have reason to believe is suspect you are liable. What is so terrific about fiduciary laws is that they carry established case law, rules and responsibilities. It's an efficient legislative move with minimal bureaucracy. In my opinion both economists of the left and right miss this.

Of course there are no economists in the real world, they are all professors, essentially left out of the professional market. The funniest is libertarians who deny professional and utilities markets even exists while they sit, in their weak profession.

(I am not making disparaging professors, just the irony that they ARE professionals nominally, while so often ignorant of the way professional markets function.) Accountants similarly are confused about professions. They too often mistakenly confuse their principal for the law. They have two principals to serve, so they may no appreciate the professional market either.
for more fiduciaries
written by David Cay Johnston, May 01, 2010 10:40
Scott makes a valid point about fiduciary duty. It is a solid gold standard, I favor its much broader application (and am married to a person whose career depends on being a strict fiuciary in both legal and moral, or normative, senses).

Yes, litigation can be used to punish disloyal conduct.
But I hate litigation and would like to see us develop solutions that reduce, not increase, litigation.
That is best achieved by setting market rules that inherently reward virtuous behavior and inherently punish vicious behavior (which I explain in my last two books).

Unfortunately, as Adam Smith warned, we tend to get the opposite.

So despite duties of loyalty, it is still much more effective, and less costly, to develop a new mechanism in which the buyers of bonds pay for the ratings.


Because there are inherent biases. News organizations have rules to deal with these. But the SEC's officially recognized bond rating companies clearly failed to deal with this. Indeed, emails show craven conduct and pandering to bond sellers.

Most bonds are bought by institutional buyers so financing reliable buy-side ratings is not impossible. We could -- and this is an extreme example to make a point -- bar underwriters from secondary bond markets to create a separate class of bond market traders with an interest in the kind of reliable information that was routine before Xerox made the 941 copier.

And, to be clear, I am not a professional economist and do not even have a degree, though I did study economics for six years, including two terms at the Chicago School in 1973. I'm an investigative reporter who has written about regulation, tax, property, bankruptcy and similar issues for decades and I now teach the historical development of tax, property and regulatory law since Hammurabi to law and grad biz students at Syracuse U.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.