Rating agencies and regulation

Jesse Walker highlights this excerpt from a recent analysis on the origins of the financial crisis by Jeffrey Friedman:

[The Recourse Rule] created a huge artificial demand for mortgage-backed bonds, each of which required thousands of mortgages as collateral. Commercial banks duly met this demand by lowering their lending standards. When many of the same banks traded their mortgages for mortgage-backed bonds to gain "capital relief," they thought they were offloading the riskiest mortgages by buying only triple-A-rated slices of the resulting mortgage pools. The bankers appear to have been ignorant of yet another obscure regulation: a 1975 amendment to the SEC's Net Capital Rule, which turned the three existing rating companies -- S&P, Moody's, and Fitch -- into a legally protected oligopoly.

The bankers' ignorance is suggested by e-mails unearthed during the recent trial of Ralph Cioffi and Matthew Tannin, who ran the two Bear Stearns hedge funds that invested heavily in highly rated subprime mortgage-backed bonds. The e-mails show that Tannin was a true believer in the soundness of those ratings; he and his partner were exonerated by the jury on the grounds that the two men were as surprised by the catastrophe as everyone else was. Like everyone else, they trusted S&P, Moody's, and Fitch. But as we would expect of corporations shielded from market competition, these three "rating agencies" had gotten sloppy. Moody's did not update its model of the residential mortgage market after 2002, when the boom was barely underway. And Moody's model, like those of its "competitors," determined how large they could make the AA and AAA slices of mortgage-backed securities.

The regulators seem to have been as ignorant of the implications of the relevant regulations as the bankers were. The SEC trusted the three rating agencies to continue their reliable performance even after its own 1975 ruling protected them from the market competition that had made their ratings reliable. Nearly everyone, from Alan Greenspan and Ben Bernanke on down, seemed to be ignorant of the various regulations that were pumping up house prices and pushing down lending standards. And the FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision, in promulgating one of those regulations, trusted the three rating companies when they decided that these companies' AA and AAA ratings would be the basis of the immense capital relief that the Recourse Rule conferred on investment-bank-issued mortgage-backed securities.

I have written previously about regulation and the role of the credit agencies here, here, here, here and here.