The Culprit Missing From the Credit Ratings Hearings

There’s something missing from today’s Financial Crisis Inquiry Commission hearing at The New School in New York.

Today’s hearing is divided into three panels: one on the ratings process, one on the role of ratings in the financial crisis, and one on the business model of the agencies. That’s one panel too few.

The missing panel? The one on the government’s role in the mess that has destroyed public and investor confidence in the century-old business of rating debt.

While there can be little doubt that the ratings process was not what it should have been, it is hard to understand why the ratings of a venerable company like Moody’s went so awry without focusing on the role of government regulation. Even more importantly, it’s impossible to understand why the poor performance of ratings agencies led to a financial crisis of such scale and extremity without delving into the role of government.

For decades, the has government all but guaranteed that the ratings process was reserved for a narrow oligopoly of just a few companies—primarily Moody’s and Standard & Poor’s, with Fitch a distant third. The main mechanism for this guarantee is a rule put in place by the SEC in 1975 that declared that brokerages and money market funds have to hold securities rated by a small clique of companies the SEC annointed as Nationally Recognized Statistical Rating Organizations.

Without serious competition, the ratings agencies had little incentive to improve their own performance. Even today, nearly every credit agreement created by a major U.S. financial institution requires a rating from Moody’s or S&P.

Eric Kolchinsky, Former Team Managing Director, U.S. Derivatives, Moody's Investors Service
Eric Kolchinsky, Former Team Managing Director, U.S. Derivatives, Moody's Investors Service

What’s more, the lack of competition left the ratings agencies unable to detect their own inadequacies. A properly functioning market process might have revealed important information about the quality of ratings to the agencies, the same way market processes tell the makers of mobile phones that they should incorporate touch screens in their smart phones. The market is a discovery process.

The rules that created barriers to entry in the ratings business also create barriers to discovering important information. They shut down the discovery process of the market. It wasn’t just that the agencies weren’t incentivized to improve their ratings—they were blind-folded and prevented from understand their own errors. They had models and expertise to rely upon, but those can go only so far without a robust market process keeping everyone on their toes.

Even today, the ratings agencies do not seem to appreciate the effect that the barriers to entry had in crippling their business. In their testimony to the Commission today, many of the witnesses insisted that Moody’s sought to provide the best credit opinions possible with the information then available. There was no recognition that their oligopolistic status—which has provided them with decades of profits—was the reason they could not detect that they were doing such a poor job.

But the stymieing of market processes doesn’t explain why outside investors—especially our most sophisticated financial institutions—relied so heavily on the ratings agencies to gauge risk.

After all, the inefficiencies of monopolies have been well-known for quite some time. And the barriers to entry in the ratings business were readily apparent. Why did so many banks continue to rely on ratings agencies despite the obvious deficiencies? And why did this cause a crisis only recently, when the barrier to entry has been in place since the 1970s?

The answer seems to lie with a still obscure regulation adopted by the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision in 2001. The regulation—which is known as the Recourse Rule—set down the amount of capital banks have to set aside against different kinds of assets.

Unfortunately, it incorporated credit ratings to judge how much capital a bank should set aside.

This means that the government essentially mandated that banks outsource their evaluation of risk to the ratings agencies. One of the witnesses, former Moody’s employee turned whistler blower Eric Kolchinsky, pointed this out in his testimony.

“Not only did private investors outsource their risk management to ratings agencies, but the government did as well….For structured finance instruments, capital rules directly relied (and still rely) on the ratings agencies. The higher the rating, the less money a bank is required to set aside for any given instrument,” Kolchinsky told the Commission.

A few questions came up today about the role of regulations but the subject seemed largely lost on the panel.

It shouldn’t be lost. Setting aside money for capital reserves is costly for banks. Every dollar used to satisfy capital requirements is a dollar which the bank cannot lend out, which mean it doesn’t earn interest. It is “dead money.” The Recourse Rule allowed banks to keep more of their capital “alive” for lending and investing—so long as they followed the ratings agency’s views of risk.

One of the people who has most acutely pointed out the poisonous role of the Recourse Rule is Jeffrey Friedman, the editor of the academic journal “Critical Review” and an upcoming book titled What Causes The Financial Crisis. In his words, the Recourse Rule “loaded the dice in favor of the regulators’ ideas of where risk did and did not lie.”

And the regulators believed that highly rated structured financial products were relatively safe. More precisely, the regulators thought that AA or AAA rated mortgage backed securities were 60 percent safer than individual mortgages, earning MBS a 20 percent risk rating while individual mortgages had 50 percent risk rating.

“The regulatory carrot altered the behavior of those being regulated, the better to align it with the regulators’ ideas about what would make for prudent banking. By thus homogenizing the heterogeneous competitive process, the regulators inadvertently made the banking system more vulnerable—if, in fact, the regulators’ theory turned out to be wrong,” Friedman writes at his Causes of the Crisis blog.

And as we know, the regulators’ theory did turn out to be wrong.

Relying on the ratings agencies to assess bank reserves was a terrible idea that lies at the heart of the financial crisis.

Terrifyingly, our banking regulations continue to rely on the ratings agencies. Even as the agencies’ executives are grilled on Capitol Hill or here in Greenwich Village, the regulators continue to encourage banks to outsource risk management to the agencies. They’re still loading the dice.

On Monday, New York Times columnist Andrew Ross Sorkin wrote: “Raise your hand if you can explain why anyone still believes in credit ratings.”

Even though the hearings today haven’t answered that question, we can raise our hands. We understand why banks still believe in credit ratings—it’s because the government still believes.

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