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Wednesday, July 27, 2011

"A Perfect Case Study of Flawed Incentives"

Ratings agencies shouldn't have so much influence:

The Biggest Driver in the Deficit Battle: Standard & Poor’s, by Robert Reich: ...All of America’s big credit-rating agencies — Moody’s, Fitch, and Standard & Poor’s — have warned they might cut America’s credit rating if a deal isn’t reached soon to raise the debt ceiling. ... But Standard & Poor’s has gone a step further: It... insists any deal must also ... reduce the nation’s long-term budget deficit by $4 trillion — something neither Harry Reid’s nor John Boehner’s plans do.
If Standard & Poor’s downgrades America’s debt, the other two big credit-raters are likely to follow. The result: You’ll be paying higher interest on ... every ... penny you borrow. ... In other words, Standard & Poor’s is threatening that if the ten-year budget deficit isn’t cut by $4 trillion..., you’ll pay more – even if the debt ceiling is lifted next week.
With Republicans in the majority in the House, there’s no way to lop $4 trillion of the budget without harming Social Security, Medicare, and Medicaid, as well as education, Pell grants, healthcare, highways and bridges, and everything else the middle class and poor rely on.
And you thought Republicans were the only extortionists around.
Who is Standard & Poor’s to tell America how much debt it has to shed in order to keep its credit rating?
Standard & Poor’s didn’t exactly distinguish itself prior to Wall Street’s financial meltdown... Had they done their job and warned investors how much risk Wall Street was taking on,... taxpayers wouldn’t have had to bail out Wall Street; millions ... would ... be working now instead of collecting unemployment insurance; the government wouldn’t have had to inject the economy with a massive stimulus...; and far more tax revenue would now be pouring into the Treasury... In other words, had Standard & Poor’s done its job, today’s budget deficit would be far smaller.
And where was Standard & Poor’s (and the two others) during the George W. Bush administration – when W. turned a ... budget surplus ... into a gaping deficit? Standard & Poor didn’t object to Bush’s giant tax cuts for the wealthy. Nor did it raise a warning about his huge Medicare drug benefit (i.e., corporate welfare for Big Pharma), or his decision to fight two expensive wars without paying for them. ...
So why has Standard & Poor’s decided now’s the time to crack down on the federal budget — when it gave free passes to Wall Street’s risky securities and George W. Bush’s giant tax cuts ... thereby contributing to the very crisis it's now demanding be addressed?
Could it have anything to do with the fact that the Street pays Standard & Poor’s bills?

Is there any evidence that ratings agencies are influenced by the fact that Wall Street pays their bills?:

Did Rating Agencies Give Preference to Big Banks?, by Matthew Philips: At the heart of the financial crisis was the market for mortgage-backed securities (MBS). These are the “toxic assets” that larded up bank balance sheets and all but froze the credit markets in the fall of 2008 ... thanks to the AAA ratings they received from the rating agencies Moody’s, S&P, and Fitch. These firms that allowed so much junk to be passed off as gold were essentially the enablers of the financial crisis.

The relationship between the rating agencies and banks is a perfect case study of flawed incentives. With banks paying them to rate their investment products, and so much money pouring in at the height of the mortgage-boom..., Moody’s, S&P, and Fitch had a strong incentive to play along.

A new study adds more fodder to the argument that these agencies were unduly influenced by the institutions whose products they were grading. It basically posits that the more MBS an institution issued, the better rating their stuff received. Here’s the abstract:

We examine whether rating agencies (Moody’s, S&P, and Fitch) reward large issuers of mortgage-backed securities, who bring substantial business, by granting them unduly favorable ratings. The initial yield on both AAA-rated and non-AAA rated tranches sold by large issuers is higher than that on similar tranches sold by small issuers during the market boom years of 2004-2006. ... We conclude that large issuers receive more favorable ratings...

    Posted by on Wednesday, July 27, 2011 at 06:48 AM in Economics, Market Failure | Permalink  Comments (71)


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