In the greatest sea battle of World War I, British Admiral David Beatty watched with uncomprehending dismay as his battlecruisers got blown out of the water, and famously remarked that: “… there seems to be something wrong with our bloody ships today.” Ninety years after Jutland, there seems to be something wrong with our bloody financial system. A big reputable investment bank like Bear, Stearns wasn’t supposed to get into such trouble that it had to be bailed out by the Federal Reserve before it blew up. One of the legacies of the last systemic American financial crisis, in the 1930s, was a regulatory system intended to ensure greater transparency for investors, some measure of confidence for bank depositors, and prudential requirements for financial institutions. Recent events suggest that this system is no longer adequate to the task. The savings-and-loan crisis of the 1980s could have slowed down the push to deregulate, but in the 1990s the Asian Financial Crisis provided a moment for self-congratulatory triumphalism about the superiority of Anglo-Saxon finance and the perils of crony capitalism. With rigorous accounting standards, regulatory oversight, and a quantitatively-based credit culture that kept lenders honest, surely the U.S. wouldn’t be vulnerable to the real estate bubbles that plagued Indonesian, Thai and South Korean banks. Or so we fervently hoped. Thus, financial deregulation and innovation proceeded apace. Today’s sub-prime mortgage crisis wasn’t supposed to happen, and now investors are haunted by the fear that financial portfolios are filled with near-worthless paper. And the baleful effects of the credit crunch are now felt widely by both individuals and firms.
There seems to be plenty of blame to spread around. Whether the finger-pointing will result in constructive action remains to be seen, but some serious ideas are being entertained. Several weeks ago, Congressman Barney Frank proposed to expand and consolidate regulation of all financial institutions, and of necessity the Federal Reserve System had to assume responsibility for investment as well as commercial banks when it orchestrated the Bear Stearns rescue. Today (Monday), Treasury Secretary Paulson is scheduled to present the administration’s own plan for regulatory consolidation (the executive summary is on the Washington Post website), and it is already getting criticized for being broad but too shallow. The several-decades-long deregulatory shift appears set to pause and even reverse itself. This crisis has produced a lot of financial grief, to be sure, but it has also created a political opportunity to do something.
One persistent problem is that financial markets are riddled by what economists term “information asymmetries.” Life is relatively simple when all market participants know what is going on, but knowledge and ignorance are very unevenly distributed when it comes to financial contracts, institutions, and instruments. Someone knew that Bear Stearns was getting deep into trouble, but it sure wasn’t me. And if the company’s share price on the New York stock exchange was any indicator, I had plenty of company (including many Bear employees). More generally, borrowers know more than lenders about their willingness and capacity to repay a loan. Such asymmetries are not easily redressed since lenders recognize that borrowers have an interest in making themselves look good enough to secure the loan. A financial market is really a market for lemons (as George Akerlof termed them).
There are a couple of general ways to deal with the problem of uncertainty. One involves acquiring more information. Another entails sharing the risks and spreading them around. Let’s look at the first strategy for now. Responding to “roaring twenties” stock market speculation and then the crash of 1929, federal legislation passed in 1934 required public companies to file regular audited reports, among other things, and created the Securities and Exchange Commission to oversee stock exchanges and enforce the new legislation. In short, companies were legally required to provide more detailed and credible information to shareholders and would-be investors. This measure was put in place because companies had been either unwilling or unable to do so without the threat of legal sanction, and so many investors went into the stock market knowing very little about what they were actually getting into. Mandating more information certainly helped, but the Enron experience of 2000-2001 showed that Generally Accepted Accounting Principles (GAAP) remain flexible enough to accommodate some highly creative accounting, and that the independence of the so-called “independent auditors” could be thoroughly subverted. A recent report (PDF) by court examiner Michael Missal on the bankruptcy of New Century Financial Corp., one of the biggest subprime mortgage originators, reminds us that the Enron episode wasn’t a one-time anomaly.
Regardless of their flaws, disclosure requirements are not the only way to generate more information and reduce uncertainty. There are private sources of information that investors can look to: the rating agencies. These have been operating in Wall Street for many decades and their judgments about the credit-worthiness of corporate borrowers have become enormously consequential. Although they now offer many services, their original business involved rating bonds. A corporation seeking to borrow money would try to sell bonds. As borrowers, however, corporations faced the problem of how to convey information about their own credit-worthiness to would-be lenders (i.e., bond buyers). This is where the rating agencies got involved, acting as independent third-parties who could offer a disinterested assessment of the borrower’s true financial situation and future prospects. This assessment came in the form of a bond rating. The highest rating was given to the most credit-worthy borrower, and entitled it to borrow at lower interest rates. Less credit-worthy borrowers would get lower ratings, and had to pay more for the money they borrowed. Borrowers understood that a good rating made a big difference for the cost of borrowing, so it was best to keep the rating agencies happy.
The oldest and best-known rating agencies are Standard and Poor’s, and Moody’s. Their long-term ratings are given as ordinal categories with, for example, “AAA” as the highest rating (for S & P), “D” as the lowest, and with “A”, “BBB,” and “BB” as some of the intermediate categories. Originally, the rating agencies made money by selling their information to clients, but now it is the firms that wish to be rated who must pay the rating agency for the privilege. The rating agencies consider themselves to be in the business of providing credible, accurate opinions about risk. They have been in operation long enough to have fine-tuned their information-gathering procedures, and as for-profit firms their products seem to have passed the market test. The big two rating agencies did not invent their methods out of thin air, but built on those previously developed in the realm of trade credit evaluation. Even before John Moody or Henry Varnum Poor rated railway bonds, the precursors of Dun and Bradstreet were busy providing assessments of creditworthiness for trade creditors (Rowena Olegario’s A Culture of Credit, Harvard University Press 2006, provides a useful historical account of the rise of Dun and Bradstreet).
Rating agencies rate many securities and instruments, offering their judgments about the creditworthiness of foreign and domestic corporations, municipalities, sovereign governments, and even some of the newer acronymic instruments that vex mortgage markets today (ABS’s, CDO’s, RMBS’s, etc). Their ratings are used widely, and have been absorbed into banking and insurance regulations. In some ways, their ubiquity and taken-for-grantedness has helped make today’s crisis particularly unnerving, for it has become clear that some serious problems were buried beneath the surface of many highly rated instruments. What looked like carefully-calibrated risks proved instead to be very unpleasant surprises.
What makes these gatekeepers of the financial market so curious is that as important as they are, little is known about how they work (one starting point is Timothy Sinclair’s The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness, Cornell University Press 2005). They may contribute to the transparency of the global marketplace, but their own inner workings are notoriously opaque. This is, of course, by design. Rating agencies wouldn’t matter if others could easily recreate or reverse-engineer the ratings they produce. What is also striking is the scant public oversight over the rating agencies. They were given special status by the SEC as Nationally Recognized Statistical Rating Organizations (NRSRO), but until recently it was unclear how they qualified. Only in 2007 did the SEC finally specify (PDF) by what criteria they granted NRSRO status.
Perhaps it is no wonder that there seems to be something wrong with our financial system. An irrationally exuberant real estate bubble was clearly a problem, but it was compounded by uncertainty about real estate values and the true worth of financial instruments secured by real estate. Although everyone recognized the need for more information, the private institutions that we rely upon to shed light on financial uncertainties are themselves rather unknown. We took easy comfort in AAA ratings without knowing enough about where such ratings came from, and without any public oversight or accountability to help resolve the mystery. We thought we were getting “credible, accurate opinions,” but instead we received opinions that sprang from the rating agencies like pronouncements from the oracle at Delphi. More transparency is a good thing, but it needs to start with those who ostensibly produce it: the rating agencies.