We learned something important at Wednesday's Financial Crisis Inquiry Commission: the power of the duopoly privilege enjoyed by Moody’s and Standard & Poor’s is what drew Warren Buffett to make his Berkshire Hathaway the biggest shareholder in Moody’s.
And what’s more: Buffett profits when the coddled nature of the duopoly encourages Moody’s or S&P to make mistakes when rating bonds.
In his testimony to the Commission, Buffett cited the “pricing power” that Moody’s enjoyed thanks to its duopoly status as what made the company’s stock an attractive investment.
“The long term value was ... the duopoly ... incredible pricing power," Buffett said.
In an earlier interview with Becky Quick, Buffett explained how this pricing power came about. “They got enshrined into various regulations. We have a life insurance company. It tells us what we can do in terms of BBB or in terms of A and all of that sort of thing," said Buffett.
So state after state has regulations relating to insurance companies that ties in with the rating agencies. And the agencies are specified. And so I can't go to the XYZ rating agency and say, ‘Will you do this for half the price,’ and have it accepted by anybody,” Buffett said.
Buffett called the creation of the duopoly a “natural evolution” in his testimony. But that is only accurate if you consider government regulations—from state insurance rules to the SEC’s designation of only a handful of companies as acceptable ratings agencies—to be a natural phenomenon.
More precisely, it was a political or bureaucratic phenomenon—the outcome of decisions regulators who may or may not have understood that they were creating barriers to entry for credit ratings.
At least two sets of regulations locked in the power of duopoly.
First, beginning in 1936 and stretching through the creation of the Recourse Rule in 2001, the regulators began to require banks, pension funds, insurance companies and money market funds to judge the riskiness of their assets according to the views of the ratings agencies.
That guaranteed that there would be a market—and a stream of profits—for ratings. Second, beginning in 1975, the SEC would formally designate which companies counted as nationally recognized ratings agencies.
It is unlikely that the regulators who anointed Moody’s and S&P with their special designation understood the consequences of their actions. There’s no record that the regulators considered how having monopoly power would encourage the agencies to become lax, no longer needing to compete over the quality of their ratings. Many investors had to accept their ratings because legally they just couldn’t shop for more accurate ratings elsewhere. If anything, it’s a wonder the flaws of the agencies remained hidden for so long.
The regulators may have actually believed that creating a finite set of ratings agencies would improve the quality of ratings. People suspicious of market processes often worry that competition will lead to a “race to the bottom.” In fact, Buffett himself takes this view.
“If there were ten ratings agencies, all equally well-regarded, all acceptable to the market, and you only needed one … they would compete on price or laxity or both. Those ten would be out there trying to get our business. I mean they might compete by price but they would also try by laxity. You could argue that if there was just one rating agency, they would have no reason to compete on either price or laxity. Independence can really come with strength in the business," Buffett told the Commission.
"Ben Franklin said that it’s difficult for an empty sack to stand straight. So if you really had a lot of competition, I’m not sure that the rating agencies would be as independent actually in coming to their credit conclusions as they are,” Buffett went on to say.
A Bond Issuer's Perspective
It would be unfair to Buffett to wonder if he is just talking his book here. Although competition between ratings agencies might damage his stake in Moody’s—remember, it was duopoly pricing power that attracted him in the first place—it’s safer to assume that he is genuinely worried about competition between ratings agencies leading to further laxity.
Why would Buffett assume that competition would lead to laxity? In part, it’s because he is viewing it from the perspective of a bond issuer. Obviously, a bond issuer would prefer to be rated by someone who would give his company a higher rating, regardless of the soundness of the business. So if competition were merely about agencies competing for business from issuers, quality might decline.
But this ignores the perspective of the bond buyer, who would prefer to buy bonds rated by the agency with the highest quality ratings.
Genuine competition would involve agencies that would have to balance their relationships with issuers with their reputations with buyers.
Bond issuers who chose trashy ratings agencies that gave junk the glitter of gold would have a hard time selling their debt. Under our current system, however, many bond buyers cannot choose to buy bonds that do not get rated by S&P or Moody’s.
Take a look at the way equity research now operates. Divorced for years now from piggy-backing on investment banking, equity research must compete the way every normal business competes—on price, speed, and on quality of the product.
Some equity analysts may sacrifice quality of research for access to the companies they cover. Indeed, the disparity between the number of sell ratings and the number of buy ratings suggests that many analysts are doing this.
But they suffer because many investors just choose to ignore the professional analysts or do the analysis themselves. Meanwhile, some star analysts who are willing to put quality first, are able to rise to the top of their field. Does the name Meredith Whitney ring a bell?
Nothing like this is permitted to occur in the bond market. Many of the buyers of bonds are large institutions that are legally obligated in one way or another to accept the views of the ratings agencies. Get rid of this obligation, and the agencies would have to compete on quality.
Already, there exist a few companies that are providing opinions about credit quality without seeking a special dispensation from the government. But they are hampered by regulations that make the views of ratings agencies sacrosanct. Why not try a free market for credit ratings?
The current system of regulations actually benefits a few of the bond buyers who are not legally obliged to outsource risk management and investment decisions to ratings agencies. Hedge funds, for instance, can profit from regulation-driven laxity in ratings by spotting misrated products. Buffett himself confessed to doing exactly this kind of thing himself.
“What we really hope for is misrated securities, because that will give us a chance to turn a profit if we disagree with how the agencies rate them,” Buffett told the Commission.
Got that? The same Buffett who profits from the duopoly status of the top ratings agencies also profits from the mistakes allowed to fester under our anti-competitive system. Perhaps we should think twice before anointing him our oracle when it comes to ratings agency reform.
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