I've been doing a lot of reading on our economy's financial institutions in preparation for a public forum sponsored by our undergraduate majors' club on the financial markets meltdown. I've been prepping to speak on the ethics involved, and I've obviously been working from my previous two posts.
In my second post, I mentioned that there many actions in this whole crisis that admitted of significant self-justification, the "good intentions" of the road-paving variety. I also mentioned there would possibly be some things discovered that, to reuse my favorite metaphor, could only be described as coming from the Death Star. I've been doing some reading on a highly technical and little known part of the crisis that is so disgusting that I'm calling it "Darth Rater". This is the saga of the companies (primarily S&P and Moody's) who provided ratings for the toxic waste securities. In case you didn't guess, the outrage is that these securities at least initially received very favorable ratings from the two companies.*
These "ratings" probably haven't received the notice they deserved. At one level they're not that complicated: These two organizations rate debt securities in a way that is not all that much different than two of my favorite non-profit organizations: Consumers' Union (at least their non-political arm, the magazine "Consumer Reports") and "Wall-Watchers" which rates Christian charitable agencies. Beyond these two examples, our society is full of ratings of everything from movies to software to football players for fantasy leagues. Often we treat these ratings game as a kind of parlor entertainment, with the fun of pitting our own opinions against those of the pros, and with very small long term consequences. I mean, I always check Consumer Reports, but what is the actual long term cost, if they are wrong, of getting the second best buy on a washing machine? However, the cases of S&P and Moody's have serious differences, as follows:
1 ) My reliance on Consumer Reports is a private transaction. However, the ratings of the financial instruments has been incorporated into the structure of public regulation. For example, according to Bloomberg and the Wall Street Journal, regulation on bank reserves, insurance companies and so-forth is sometimes keyed to the ranking of the securities by the two agencies. Consider the following: I can read Consumer Reports and choose to heed or ignore their ratings of new cars.... that's a purely private transaction. But if I were appointed as a trustee of the investments of a church, and the by-laws required that I only invest in securiteis of a specific quality as rated by S&P or Moody's, then I am not free to ignore that requirement. If I am a banker, and government regulations make a similar requirement, then the decision to rely on the ratings becomes explicitly a matter of public policy.
2 ) Requirements about trustees and bankers that I mentioned above are another example of my "... Good Intentions" thread. We want church trustees and banks to make wise decisions. But when put that expectation in terms of structured regulations, there is a huge incentive for CYA activity of relying solely on the outside raters and not on one's own independent investigations. But, according to the Wall Street Journal, these professional opinions may be less informed than what an informed layperson could "read in a newspaper." Playing if safe by relying on Moody's or S&P rather than on one's own judgment is another example of Moral Hazard.
3 ) Private reliance on raters is subject to market discipline. My wife and I once invited friends over for dinner and a DVD which a movie reviewer had labeled something like "a light-hearterd comedy". The movie turned out to be full of graphic sexual references and cannibalism. That was the last time I paid any attention to that reviewer. If Consumer Reports or movie reviewers persistently make bad recommendations, presumably they will suffer in the market place for opinions. But governments, specifically the federal government, have enshrined Moody's and S&P as a part of a tight, government sponsored oligopoly so that they are not subject to as much market discipline. If you want your securities rated, you have very little choice but to play ball with Moody's and S&P.
4 ) Consumer Reports and Wall Watchers get their money from the consumers of the rated good and organizations, in the form of donations and (for Consumer Reports) subscriptions and sales. Consumer Reports will not carry advertising. Obviously, issues of popularity factor into their decisions as to which goods and organizations to rate. There are some obscure appliances or tiny non-profits that simply can not be handled. However, securities issuers are put in a position (because of the regulatory requirements mentioned above) that their products must be rated. Therefore, it is the securities issuers who pay for the rating services. Or, to say the same thing another way, the ratings companies make their money from the issuers of the securities they are rating. I can imagine that you can see where this is going.... To Be Continued.
* See especially a two-part September series in Bloomberg and an article in the Wall Street Journal.
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