Rating agencies have been blamed by many as major contributors to the 2007-2009 financial crisis, and even as THE major contributors by some.Â Significant new regulations have been put in place and others have been proposed on how to restructure this market.Â Though some changes may be in order, there is a danger of over-regulation, or writing regulations which address a fundamental misdiagnosis of the problem, with predictable and undesirable consequences.
As just one example, a recent proposal put forward in Europe advocates capping the market shares of rating agencies as a way of promoting competition in the European market.Â Such an approach could in fact cause more problems than it solves:
- First, part of the value of ratings stems from the fact that they represent internally consistent measures of relative credit risk.Â Hence, all else equal, a rating system becomes more valuable the more of the universe it applies to, and restricting market share diminishes this value.Â
- Second, credit analysis of issuer A often requires credit analysis of issuer B.Â Consider the relationship between banks, or between banks and sovereigns, or between parents and subsidiaries in a corporate family.Â In order to do a proper analysis of issuer A, the rating agency may need to do a proper analysis of issuer B.Â Not allowing the agency to be paid for its analysis of B amounts to insisting either that the agency conduct the analysis for free, or that it forego the analysis and render a suboptimal credit opinion of A.Â
- Third, how would this system be managed?Â If an issuer wants to pay a rating agency for a credit opinion, is the government going to say, no, you can’t?Â Which governmental agency?Â And will that agency decide who will win this customer instead?
- Finally, and perhaps most fundamentally, it is not at all clear that the problem in the rating industry is a lack of competition.Â Competition, i.e., a larger number of competitors in the market, typically leads to a lower price for the same quality product, or higher quality product for the same price, but does not always have to lead to an absolutely higher quality product, which is the presumed goal of the new regulations.Â In the case of ratings, increasing competition may introduce greater pressure for ratings shopping, which seems to be the main problem.Â Why would an issuer not just pay for the highest rating anyone is willing to sell?Â The result will not be better ratings, just higher ratings.Â Introducing the ACME Rating Agency, which sells AAA ratings for $50 a piece, might be said to increase competition, but it can hardly be said to surely foster better ratings.
It is important to be aware that over-regulation of the financial sector is a real danger.Â University of Chicago Professor John Cochrane, provides some insights into this problem in his article Lessons from the Financial Crisis (www.cato.org/pubs/regulation/regv32n4/v32n4-6.pdf).
Additionally, it is also important not to try to overfix a market.Â In my view, though rating agencies did contribute to the financial crisis, there is a lot of blame to go around.Â A growing view in academia, argued by Professor John Taylor of Stanford University, for example, points to loose monetary policy as one of the leading causes of the financial crisis.Â Monetary policy has been linked to other major economic downturns.Â Tight monetary policy has been pointed to by many as an aggravating factor to the Great Depression, and it has also been viewed as inducing the recession of the early 1980’s, though in the latter case it may have been an unavoidable correction for the loose money of the 1970’s.
According to this inflationary bubble argument, as a consequence of artificially low interest rates maintained throughout the 2000’s, financial institutions were willing and able to lower their standards when making credit available for mortgages.Â It also incentivized (and allowed) borrowers to refinance their existing mortgages.Â This resulted in an unprecedented correlation of loan-to-value (LTV) rates in the market.Â Whereas typically a cross-section of the market would reveal a range of LTVs, reflecting in large part that some mortgages are new and others old, the significant refinancing led to a concentration of high LTVs all at the same time, since lots of mortgages were effectively new. Â When house prices began to decline, rather than finding some borrowers with low leverage and others with high, the market was overrepresented by highly levered borrowers who, simultaneously, found their home loans underwater.Â The result, according to this argument, was a surge in mortgage defaults, not because people with 50 percent LTVs were necessarily defaulting, but because there were artificially too few people with 50 percent LTVs.
Again, according to this argument, the mechanism by which this artificial liquidity was funneled into the mortgage market was securitization.Â Banks were willing to extend credit to subprime borrowers first because the credit was cheaply available from the Fed, and second because the mortgages could be sold into securitized pools.Â The risk could be tranched and sold to different market intermediaries with different risk appetites.Â That this risk was improperly assessed by the rating agencies and almost surely exacerbated the crisis.Â But did it cause the crisis?Â Fundamentally there must have been a source of the cheap credit which was extended to homeowners; the mechanism of that transmission”mis-rated securitizations”seems of second if not third order importance.Â Or so this argument goes.
The latest CPI Antitrust Chronicle (available at www.competitionpolicyinternational.com/apr-12/) contains four articles dedicated to Credit Rating Agencies and Regulation.Â These articles explore the contribution of rating agencies to the financial crisis, the potential anticompetitive issues in this market, and which policy avenues should be pursued.Â This issue also provides a description of the accuracy of Moody’s Investors Service’s one-year-ahead corporate default forecasts made throughout the financial crisis.Â All in all, an interesting read.