On Wednesday morning Planet Money’s Jacob Goldstein was on NPR’s Morning Edition discussing the role of credit rating agencies in the economy, in the wake of the signal earlier this week from Standard & Poor’s regarding their assessment of the quality of U.S. Treasury debt. The statement itself had only a fleeting negative effect on U.S. equity markets, and has not translated into changes in bond yields, despite the widespread acknowledgment that their perception of U.S. government debt is consistent with the beliefs and expectations of other observers and analysts.
But what I really appreciated in the story was an exchange between Goldstein and host Mary Louise Kelly that reflects the first question that popped into my mind on hearing of the S&P statement: why does anyone even place any weight on their pronouncements?
KELLY: And why should we pay attention, generally speaking, to pronouncements from S&P or the other rating agencies – the other big two being Moody’s and Fitch. I mean, they turned out to be incredibly inaccurate in the financial crisis, lots of mortgage-related bonds that they rated very highly turned into junk. Why trust them?
GOLDSTEIN: That’s a great question. They certainly got a black eye in the financial crisis. But despite whatever their performance may have been, the big ratings agencies, they’re still written into the laws and the regulations that govern our financial system. So, for example, if rating agencies lower their rating, that can force banks and insurance companies and other big financial firms to sell off that country’s bond. So the rating agencies still do matter.
KELLY: You say that their influence is written into the law, but these are not government agencies. How is it, exactly, that they work?
GOLDSTEIN: They’re private companies. And when they rate corporate bonds and mortgage bonds, it’s actually the companies that they’re rating that’s paying them. So it is this very strange hybrid, right? On the one hand, they’re private. They make a profit. But on the other hand, the law gives them this special position in the financial system.
Where I’m from we call that “special position” a conflict of interest that creates perverse incentives.
After all of the putative attention to increased financial regulation, the purported increase in consumer protection in retail financial transactions, I am still flabbergasted that the “special position” of the credit rating agencies has not been modified. They have managed to dodge what I think is some very well-deserved criticism for their role in perpetuating the unrealistically optimistic expectations about returns on mortgage instruments and their derivatives. Some of the best critical analyses I’ve read come from Gillian Tett at the Financial Times (the article is an excerpt from her book Fool’s Gold).
In a similar vein as the TSA’s “security theater”, all of the sound and fury of the financial regulation of the past two years is “regulatory theater” as long as these deep, perverse incentives are not addressed. Regulatory theater may make some financial consumers and their elected representatives feel more secure, but it’s window dressing compared to core perverse incentives such as those under which the rating agencies operate, and it’s therefore a waste of our money and resources.