CEPR - Center for Economic and Policy Research

Multimedia

En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press There Is a Simple Solution to the Conflict of Interest of Bond Rating Agencies

There Is a Simple Solution to the Conflict of Interest of Bond Rating Agencies

Print
Friday, 22 August 2014 05:22

Floyd Norris had an interesting piece discussing the conflict of interest problems with company auditors and also the bond rating agencies that rate securities issued by banks. The basic problem is that since both are paid by the companies who hire them, they have a strong incentive to give a positive assessment regardless of the reality of the situation. This was a huge problem in the housing bubble years when the credit rating agencies gave trillions of dollars' worth of mortgage backed securities top investment grade ratings even though they were filled with dicey mortgages.

In fact, there is a relatively simple solution to the conflict faced by bond rating agencies which actually was put forward as part of Dodd-Frank. Senator Franken proposed an amendment, which was approved overwhelmingly in a bi-partisan vote, which would have had the Securities and Exchange Commission (SEC) pick the credit rating agency. (I worked with Senator Franken's staff on designing this plan.) This plan would have eliminated the conflict of interest since a negative rating would not reduce the probability of being hired for further work.

This amendment was stripped out in conference committee, with the support of the Obama administration, as Timothy Geithner indicated in his autobiography. The argument against the proposal said a great deal about the corruption underlying the debate on this issue.

The concern was supposedly that the SEC might choose a rating agency that wasn't qualified to rate a particular issue. The absurdity of this concern should be apparent on its face. The SEC would not be sending Bozo the Clown to rate these issues, they would be sending professional auditors. Of course the correct way for a professional auditor to respond if they see an issue they don't understand is to say that they can't rate it, which would then allow the SEC to pick an agency that has auditors who can rate it.

However there is an even more basic issue, why are banks securitizing issues that professional auditors can't understand? It is highly likely that if the professional auditors employed by credit rating agencies can't understand an issue then many of the investors who will buy the issue also will not be able to understand it. In that case, it is probably best for the economy that the issue not be marketed.

All of this should be pretty evident on a moment's reflection, but in a world where Wall Street controls the debate on such issues, this simple logic was completely excluded from the debate.

Comments (9)Add Comment
Self Regulation is a Virtue, not an Incestuous Relationship
written by Last Mover, August 22, 2014 7:54

Keep the government out of it. Keep SEC enforced competitive choice out of it. Let private business regulate itself. It knows best because it does the business itself. It is close to all the issues that others will never understand as they willy nilly suppress it with mountains of useless red tape.

Don't you understand America? Private business never cannabilizes itself with fraudulent products because customers will catch on and stop buying the goods. This is a backstop to ratings agencies that has always worked to allow competition and choice to drive resources (in this case bonds) to their highest valued use.

For example it drove house prices to their highest valued use didn't it? What more could you ask for?

Paying the referee who oversees the rules of the game just gets better referees. They respond to incentives like anyone else.

Just because the referee misses a few critical calls that would change the outcome is not the issue. The issue is whether the referee adds the correct value to the product in question.

As DB points out rightly for the wrong reason, if the referee as on-the-fly auditor-in-chief doesn't understand the issue, the obvious solution is to pick one who does by paying more accordingly for the specialized skills and preferred calls in question.

Self regulation is the answer America. Let the free market depend on referees acquired at the highest bid for their services. The only exception is the 99% who by all means must be forced to play on an objective and impartial level playing field as prices takers rather than price makers.
Geithner
written by Ho Ho, August 22, 2014 8:25
Always such a putz. Corrupt as hell underneath a facade of bureaucratic concern.
....
written by djb, August 22, 2014 8:30
so in essence the government would be rating the security or at least the rating agency would have to meet standards that the government set to get picked
I will correct that for you.
written by Bill H, August 22, 2014 8:32
Of course the correct way for a professional auditor to respond if they see an issue they don't understand is to say that the bond is junk and should not be marketed. There.

Actually, rhe rating of bonds and similar instruments should probably be an integral function of the SEC.

...
written by Bloix, August 22, 2014 9:30
I have read synthetic CDO's and concluded that they cannot be "understood," because they leave the determination of certain crucial events to the sole discretion of the issuer, and the definitions of these events are ambiguous. There is no public market in these securities so the events cannot be determined by a recourse to market prices. A purchaser cannot predict in advance the odds that an event will take place, and has no right to contest afterwards whether it has taken place.
Thanks for the background
written by Dave, August 22, 2014 9:56
It is nice to find places like this where we can get an inside view of how things work.

Franken knows how to do his job. Not many up there do.

I think it is time for America to start electing serious presidents. We don't need overconfident lazy people in the post.
...
written by jm, August 22, 2014 10:25
Dean wrote, "However there is an even more basic issue, why are banks securitizing issues that professional auditors can't understand? It is highly likely that if the professional auditors employed by credit rating agencies can't understand an issue then many of the investors who will buy the issue also will not be able to understand it. In that case, it is probably best for the economy that the issue not be marketed."

In fact if it's that complex, it's likely the people issuing the security probably don't really understand it. Back in the '70s Fortune ran an article entitled something like, "The Brilliant Taxophobe of Baldwin-United," in which the "Brilliant Taxophobe" was praised by most interviewees as having come up with tax avoidance strategies beyond the understanding of anyone else. One interviewee, however, had the cheek to opine that he suspected that if he couldn't understand them, the guy who'd come up with them probably didn't, either. Which turned out to be the case -- the company was rent asunder soon after.

And might we recall the similar case of Enron -- the smartest guys in the room.
Geithner - GOP mole?
written by Reluctant capitalist, August 22, 2014 3:45
I lost much enthusiasm when Obama chose Geithner and Larry Summers. And my hopes that the financial system would undergo a roto-rooter type cleansing diminished to zero within a few months into 2009. I have to admit, Geithner was quite an efficient obstacle to meaningful improvement, as Sen. Elizabeth Warren can attest. But, if the boss didn't approve of his actions, he would have fired him.
...
written by dax, August 25, 2014 8:59
"However there is an even more basic issue, why are banks securitizing issues that professional auditors can't understand?"

And there is an even more basic issue. Why do banks have products on their books that the regulators can't understand? How are the regulators supposed to regulate?

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.

busy
 

CEPR.net
Support this blog, donate
Combined Federal Campaign #79613

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.

Archives