Warren Buffett’s Anti-Competitive Profits

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

BRK.A loading...

Quote  |  Chart  |  News  |  Profile

[BRK.A  Loading...      ()   ] the biggest shareholder in Moody’s.

And what’s more: Buffett profits when the coddled nature of the duopoly encourages Moody’s

MCO loading...

Quote  |  Chart  |  News  |  Profile

[MCO  Loading...      ()   ] or S&P to make mistakes when rating bonds.

John Carney
CNBC Senior Editor

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.

Getty Images Warren Buffett

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.