In an article at The Economist Lawrence Summers considers the historical structure of recent finanicial crises and asks a series of questions:
- should bank capital standards or countless investment guidelines be based on ratings? What is the alternative?
- Second, how should policymakers address crises centred on non-financial institutions?
- Third, what is the role for public authorities in supporting the flow of credit to the housing sector?
I have more basic questions and perhaps some smart person can step up and answer them for me. If, as Dr. Summers notes, the ratings agencies dropped the ball, why? Human imperfection? Lack of the tools for analyzing the instruments they were rating? Misrepresentation of the tools or, possibly, that those offering the instruments themselves didn’t understand them? What?
It’s unclear to me that an effective regulatory reform (if such is possible) could be formulated without knowing the answers to those questions.
However, remedial action need not wait on the answers and that’s how Dr. Summers concludes his article:
But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.
Bad incentives mate, bad incentives. I’d go to FT and read their Sub Prime primer. http://www.ft.com/indepth/subprime
Specifics on request, but not that hard to tease out mate, if you look at how they’ve been compensated.
By the way, on FT the articles of Gillian Tett are invaluable for understanding the present situation.
I cite
http://www.ft.com/cms/s/0/91d29ae2-51da-11dc-8779-0000779fd2ac.html
http://www.ft.com/cms/s/0/8d97fe00-4ac7-11dc-95b5-0000779fd2ac.html
http://www.ft.com/cms/s/0/8479d180-4eb5-11dc-85e7-0000779fd2ac.html
And a particularly nice discussion by Tett of the issue of ‘contaminated ratings’
http://www.ft.com/cms/s/7b74194a-1a91-11dc-8bf0-000b5df10621.html
Also a discussion of rating agency issues as editorial comment from a few days ago (although I am not sure I particularly agree with their advice, the issues identified are real enough):
http://www.ft.com/cms/s/0/bcdfed7a-518f-11dc-8779-0000779fd2ac.html
Also Lex:
http://www.ft.com/cms/s/1/073280b4-4b63-11dc-861a-0000779fd2ac.html
And rating shopping;
http://www.ft.com/cms/s/cf7d53ec-1395-11dc-9866-000b5df10621.html
My answer:
Black-box complexity in modelling, excessively complex transactions little understood re full risk, rating agencies becoming slowly addicted to a fat new income stream….
How to fix this is a bit unclear though. Rather obviously though, as the editorial comment on rating agencies notes, the incentive structure that once made the ratings system fairly self-correcting has been knocked out of line by unintended consequences.