Wednesday, April 15, 2009

The rating agencies

Earlier this month I wrote a brief analysis on the origins of the financial crisis in which I imparted a large portion of the blame on the credit rating agencies, which are endorsed by government regulators. Today's Wall Street Journal has an editorial that calls for an end to such intervention, which it calls a "government-created oligopoly in credit analysis":
Virtually everyone who has reviewed the causes of the meltdown has concluded that credit ratings were a major factor.

Instead of a free market judging the likelihood that a particular bond will be repaid, regulation by the SEC and Federal Reserve forces market participants to use the government's hand-picked experts at Standard and Poor's, Moody's and Fitch. Since 1975, the SEC has anointed a small group of firms as Nationally Recognized Statistical Rating Organizations (NRSROs), and money market funds and brokerages have no choice but to hold securities rated by them. To this day, the Fed will only accept assets as collateral if they carry high ratings from S&P, Moody's and Fitch.

We aren't urging the Big Three to yank the U.S. Government's AAA rating as a show of independence. But we are suggesting that the SEC and Fed get out of the business of dictating which firms may judge credit risk.

Peter Fisher at Blackrock argues that it's time to abolish the NRSRO designation for entire firms and instead allow individuals to become licensed to do credit analysis, like brokers and equity analysts. Law professor Mr. Partnoy (scheduled to address the SEC today) argues that instead of relying on the failed ratings agencies, regulators should harness the power of the bond and credit default swap markets, which yielded more accurate readings on the default risk of firms like Bear Stearns.

Those ideas deserve debate, but the starting point for reform must be ending the government-created oligopoly in credit analysis.
Note that bolded part. The less regulated credit default swap markets were more accurate than the regulated credit analysis firms. Government's solution? Regulate the credit default swap markets!

I think the problem here is that, as Thomas Sowell pointed out yesterday, people are accepting words in place of realities. Problem with the credit markets? Solution: regulate them with government bureaucrats watching over. This makes intuitive sense, with the government imposing order where there previously was none. Or so it seems.

What this approach fails to understand is that the private sector is already sufficiently regulated. The regulators are the general public. If a product is substandard we vote with our money and decide not to buy it. If we don't like the way a company is operating we can decide not to do business with them. That's really the ultimate regulation of a company's behavior.

When the government decides to regulate something they take that freedom away from us and place it in the hands of a select few, who often do not possess the same level of self-interest as ourselves. We should not be surprised when the results suffer accordingly.

Update: More on the impact of government regulation here.

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