Looking for the Real Killers (Updated)

Financial system killers, that is. The search for culprits in the financial crisis proceeds apace with the New York Times pointing a finger at the rating agencies:

Moody’s, Standard & Poor’s and Fitch, whose ratings assured investors that the newfangled investments were as safe as United States Treasury bonds, arguably bear as much responsibility for the financial crisis as the banks that put the investments together. But the raters have mostly avoided public scrutiny, and from the look of Democrats’ current proposals to overhaul financial regulation, it looks as if they will remain off the hook.

While I agree with the Times editorial writers that the rating agencies deserve a lot more scrutiny their analysis and prescription are hopelessly confused:

And yet, the financial reform bills before Congress have only vague proposals to fix the agencies. They would have to register with the Securities and Exchange Commission, and the Senate bill would allow the S.E.C. to pull their registration if they were consistently wrong. Raters would have to disclose conflicts of interest, and investors would be able to sue for blatant recklessness.

That is not enough. Some good ideas are floating around to do much better. If raters are considered to be a public good, they should be financed like a public good, with a tax or other levy, and paid by the government. Another option would be to let banks pay for ratings but take away their ability to choose who rates their bonds, letting the S.E.C. decide based on raters’ performance.

Like many the editorial writers have confused “public good” with “good for the public”. A public good is by definition a good that is non-rivalrous and non-excludable. “Non-rivalrous” means that the consumption of the good by one individual does not reduce the availability of the consumption of the good by others; “non-excludable” means it is difficult or impossible to exclude others from the consumption of the good. National defense is a public good defending me does not reduce the availability of defense for you and it is practically impossible to exclude your defense if I am being defended.

So, for example, however good it is or needed by the public healthcare is not a public good because it is rivalrous and excludable. That’s just what the words mean.

I believe that the Times editorial writers are confusing public goods with public utilities. The three nationally designated rating agencies (Moody’s, Standard & Poors, and Fitch) receive an enormous subsidy from the government in the form of the federal requirement in accord with international accords that any financial instrument be rated by one of these agencies. That doesn’t make them a public good but something more akin to a public utility. Unfortunately, they are not regulated nearly as strictly as a public utility should be and, if they are to continue to retain their oligopoly, I believe that greater regulations are in order.

Paul Krugman recently proposed that companies be assigned rating agencies rather than picking their own thereby avoiding the conflict of interest the Times is complaining about. I’ve proposed that rating agencies be held accountable in some concrete fashion for the ratings they provide. None of the solutions I’ve heard are particularly satisfying or effective and, clearly, the status quo is unacceptable.

Most of all the alternative, mentioned by the Times, of making providing ratings an official function of the federal government, is utterly unacceptable. Has the Times never heard of regulatory capture? Do its editors not realize the role that regulatory capture played in the financial crisis?

Speaking of the role of regulatory capture in the financial crisis billionaire publisher and real estate mogul Mort Zuckerman notes the role of Congress in the financial crisis:

What we have learned from the financial crisis is that we not only had institutions that became too big to fail, but also some that became too interconnected to fail. Today, roughly 90 percent of over-the-counter trading in derivatives is between two financial entities, including banks, finance companies, pension plans, insurers, and hedge funds. The danger is the domino effect—that one entity’s failure can mean a run on the other, which is interconnected through their derivatives. This poses difficult decisions for public officials.

What we now need is to greatly reduce the risks of a domino effect (and a government bailout) by imposing standards for over-the-counter derivatives so they can be cleared by central clearinghouses.

But we also need to understand how the housing market got as hot as it did. Why did it keep rising, generating more and more derivatives geared to a rising market? It turns out that Fannie Mae, Freddie Mac, and the Federal Housing Administration had financed a lot more subprime and Alt-A (alternative documentation) loans than anyone realized, mostly as a result of congressional mandates. Indeed, of their total outstanding mortgage portfolios of $10.6 trillion, roughly half turned out to be of low quality. Had this been known, it would have been clear that the American public’s capacity to assume this amount of housing debt was at great risk.

That is at the heart of the now-famous Goldman-Paulson saga. Hedge fund manager John Paulson judged that the housing market was a bubble, so he shorted the securities through Goldman Sachs and an insurer called ACA, which sold the package to a German bank. The buyers judged that it was safe to count on housing prices continuing to rise. They chose which mortgage securities would be bundled by Goldman. And they have paid a heavy price for their judgment.

Unfortunately, Congress has not paid a similarly heavy price for its folly and it is unlikely to do so in the foreseeable future. Even if there’s a notable turnover in the November elections the majority of incumbents will be returned to office.

I am not one of those who believe that Americans have the government that we deserve. I think our government in which incumbents are supported by corrupt districting and seniority systems is far worse than we deserve. And short of a complete collapse I see very little in the way of a remedy on the horizon.

Update

While we’re looking around for culprits, let’s not forget Robert Rubin, whom Felix Salmon referred to aptly and wryly as the “Forrest Gump of the financial crisis”. Salmon restates his bill of indictment for Rubin here. At the very least former Treasury Secretary Rubin should be shunned.