Ratings Agencies and Unspoken Goals

Let's start with Megan McArdle's follow-up post to her rumination about the ratings agencies.

Yesterday, I asked what we should do about the fact that ratings agencies were so drastically underestimating tail risk of the securities they rated. Today, Joe Wiesenthal at Clusterstock offers a possible solution....

For some reason McArdle doesn't cut-and-paste most of Wiesenthal's solution. Maybe the reason is that he is simply trying to find a way to avoid regulating something that must be regulated or it will get out of control, as the ratings agencies have. They gave good ratings to junk securities because it was profitable and nobody stopped them. Regulation would be a start to end the ratings problems, but regulation is evil to good little free-market Fairy followers. Here's the rest:

If a debt issuer isn't happy with who they got, then, well, too bad. Over time, you'd give companies that showed a good track record a heavier weight in the pool, so that they're selected more often. Their only goal would be to increase market share by being accurate.Pandering to either buyers or sellers would be 100% impossible.

Now granted, it wouldn't be perfect. Performance measures would be backwards looking, and you'd probably end up with companies that had gotten lazy, and stuck to old ideas about how to rate debt, but that's just life. They'd lose their weighting in the pool, and eventually you could even put companies on probation if they got bad enough.

Nothing's going to change the fact that incumbents grow dumb and slow--but at least they'd have an incentive to avoid that, whereas currently they don't (have the top raters lost any market share? No.)

There's your solution.
[my bold]

In other words, a market that is regulated. My understanding of economics is limited, but if we had regulated the ratings market properly in the first place we wouldn't be in so much trouble now. So I went back and read about six articles on ratings agencies also published on Business Insider, a magazine that tries very hard to live up to its name. The overall goal of the magazine seems to be to discourage any regulation of ratings agencies. From "Don't Blame The Ratings Agencies" by John Carney (a big defender of McArdle):

In a competitive market place, different companies structure their enterprises according to different ideas. In a counter-factual world of openly competing credit advisors, each rating agency would have had to experiment with different theories about credit risk and adjust their theories according the market’s reaction. The process of competition would have worked to produce better ratings by putting the bad credit advisors out of business.

Now it’s very possible that errors in ratings would still happen, and bad ratings companies may even come to dominate for a time because the market mistakenly preferred the wrong rating theory. But a competitive market for ratings would have at least had a chance of producing a better result, and likely would have over the long term.

Isolated from the feedback of the market, the ratings agencies lacked an exogenous indicator about the quality of their ratings. They were left to guess whether or not they were employing the right system, like the socialist shoe maker who just has to guess how many shoes he makes because there’s no price system. Arguments about how to rate mortgage bonds were reduced to just that—arguments that could only be cognitively evaluated rather than tested in the marketplace.

In short, the very laws that protected the ratings agencies marketshare and guaranteed them business, also destroyed the competitive process that could have led to the discovery of better ways to evaluate bond risk. The agencies were victims of the regulatory framework, rendered blind to their own errors.

You see, it was government interference that caused all the problems, not the rampant greed and dishonesty of the Bush Business Philosophy: Give me your money because I deserve it.