The always interesting, occasionally brilliant Matt Yglesias published one of the best headlines ever: S&P Legal Defense—No Reasonable Investor Would Take Us Seriously. (For the time, I will ignore his outrageous misuse of the em-dash; it should have been a colon.) The article is about the $5 billion civil case against Standard & Poor's. The case against them is that they weren't acting as a rating agency; they were just giving firms whatever ratings they asked for. Their defense is that their claims of objectivity are nothing more than "puffery." And yes, that's the word they use.
Yglesias argues that if this is the case, it is time to get rid of the credit rating agencies. He wrote, "That need to maintain a credible brand should give raters a financial incentive to avoid giving positive ratings to bad products even ifthey're being offered money to do that. But this entire logic rests on the theory that claims to objectivity and independence aren't puffery—that they're actually at the core of the ratings agencies' business model." So let's get rid of them. That's his take away from this whole thing.
Ah, Grasshopper! Your naivete is charming. The credit rating agencies were never given their power because they were credible, although at one time they might well have been so. They were always given power to pronounce this or that investment good or bad because they were the right kind of people. All one really needs to reasonably assess an investment's value is some investigators and mathematicians. Given this, ratings agencies ought to be pretty easy to start. But there are only three of them. Being accurate has nothing to do with being "credible" on Wall Street. "Credibility" is all about being one of the boys.
Clearly, we need rating agencies. If people are going to invest a lot of money, they need a way to gauge that risk. But the way the system works is exactly the opposite of the way it ought to exist. Even Yglesias seems confused on this point; he wrote, "As a theoretical matter, the business model in which the issuer of a security pays a ratings agency to evaluate it can make sense." Really?! I would think that as an investor, I would want to hire my own firm to judge the investment. That way, I would know that I wasn't hiring some lackey paid by the investment seller to say that I was buying a AAA investment when I was really buying junk bonds.
Yglesias is right that the rating agencies ought to go the way of the Dodo. But they won't. In fact, the system won't even be reformed. If S&P ends up having to pay $5 billion for their bad ratings, it won't change its industry standing, other than making it even more "credible." Dean Baker presented an excellent way of using the existing system in a way that didn't facilitate corruption. Instead of allowing the bond issuers to hire whatever firm they want, have the government randomly assign a rating agency. That would be simple and efficient and fair. But the bond issuers would not like it, because it would stop them from gaming the system. And the rating agencies would not like it, because it would stop them from getting extra money by telling their employers what they want to hear. And given that, nothing will happen.
Have I told you recently that we don't live in a democracy?
(Cross-posted at Frankly Curious.)
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