Credit ratings agencies have taken a lot of heat for the subprime meltdown, with the apparently true accusation leveled against them that their ratings were optimistically and unrealistically high for traded derivatives based on subprime mortgage loans. But according to economist Charles Calomiris, the regulatory framework unintentionally rewarded what were essentially fake ratings. The excerpt of the article where he discusses the four regulatory signals to the agencies to lie is very long, so I've stitched together the four main points. Since it's highly redacted, I'm not going to indicate where the cuts are, but you can find the text on pages 31–36:
Insurance companies, pension funds, mutual funds, and banks all face regulations that limit their ability to hold low-rated debts, and the Basel I and II capital requirements for banks also place a great deal of weight on rating agency ratings. By granting enormous regulatory power to rating agencies, the government encouraged rating agencies to compete in relaxing the cost of regulation (through lax standards). Rating agencies that (in absence of regulatory reliance on ratings) saw their job as providing conservative and consistent opinions for investors changed their behavior as the result of the regulatory use of ratings, and realized huge profits from the fees that they could earn from underestimating risk (and in the process provided institutional investors with plausible deniability).
Unbelievably, Congress and the SEC were sending strong signals to the rating agencies in 2005 and 2006 to encourage greater ratings inflation in subprime-related CDOs! In a little known subplot to the ratings-inflation story, the SEC proposed “anti-notching” regulations to implement Congress’s mandate to avoid anti-competitive behavior in the ratings industry (Calomiris 2007a). The proposed prohibitions of notching were directed primarily at the rating of CDOs, and reflected lobbying pressure from ratings agencies that catered most to ratings shoppers.
This effectively would have further emboldened the most lenient rating agencies to be even more lenient to ratings shoppers, since it effectively would have required the relatively conservative agencies (e.g., Moody’s) to accept the ratings of other agencies in repackaging securities rated by others. Unbelievably, the SEC agreed that notching was anti-competitive and proposed to prohibit notching. In light of the CDO debacle, and a flood of criticism from academics (including myself), the SEC quietly withdrew this proposed anti-notching regulation (at least for the time being). But it still contributed to the subprime rating problem. In the face of the threatened anti-notching rule, the likely response by the relatively conservative rating agencies was to loosen their ratings standards on subprime MBS and CDOs.Changes in prudential bank capital regulation introduced several years ago relating to securitization discouraged banks from retaining junior tranches in securitizations that they originated, and gave them an excuse for doing so. This exacerbated agency problems by reducing sponsors’ loss exposures. The regulatory changes relating to securitization raised minimum capital requirements for originators retaining junior stakes in securitizations. Sponsors that used to retain large junior positions (which in theory should have helped to align origination incentives) no longer had to worry about losses from following the earlier practice of retaining junior stakes. Indeed, one can imagine sponsors explaining to potential buyers of those junior claims that the desire to sell them was driven not by any change in credit standards or higher prospective losses, but rather by a change in regulatory practice – a change that offered sponsors a plausible explanation for reducing their pool exposures.
More fundamentally, the prudential regulatory regime lacked any device for ensuring that bank risk would be adequately measured or that capital would be commensurate with risk. As Adrian and Shin (2008) show, both risk and leverage increased during the subprime boom, which provides prima facie evidence of the regulatory failure to measure risk and budget capital accordingly. Interestingly, Calomiris and Wilson (2004) show that in the 1920s this was not the case. During that lending boom, as banks’ risks increased, market discipline forced banks to reduce their leverage in order to limit the riskiness of their deposits. In the presence of deposit insurance and anticipated too-big-to-fail protection, however, debt market discipline is now lacking. If prudential regulation fails to limit risks, banks may fail to maintain adequate capital cushions. The recent failure of banks to maintain adequate capital in the face of rising risk suggests a need for fundamental reform of prudential regulation, which is explored in detail in Section III.The regulation of compensation practices in asset management likely played an important role in the willingness of institutional investors to invest their clients’ money so imprudently in subprime mortgage-related securities. Casual empiricism suggests that hedge funds (where bonus compensation helps to align incentives and mitigate agency) have fared relatively well during the turmoil, compared to other institutional investors, and this likely reflects differences in incentives of hedge fund managers, whose incentives are much more closely aligned with their clients.
The typical hedge fund compensation structure is not permissible for some other, regulated, asset managers. Mutual fund managers must share symmetrically in portfolio gains and losses; if they were to keep 20% of the upside, they would have to also absorb 20% of the downside. Since risk-averse fund managers would not be willing to expose themselves to such loss, mutual fund managers typically charge fees as a proportion of assets managed and do not share in profits. This is a direct consequence of the regulation of compensation, and arguably has been a source of great harm to investors, since it encourages asset managers to maximize the size of the funds that they manage, rather than the value of those funds. Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace, and not to return funds to investors when the return relative to risk of their asset class deteriorates.
Did you catch that part in the third point about federal deposit insurance creating a moral hazard that exacerbated the crisis in a way that didn't happen in the run-up to the Great Depression? Also, though I didn't excerpt it, in the section right before this one, the author argues pretty convincingly that the big institutional investors using the ratings agencies were aware of the unrealistic assumptions that the ratings were based on (i.e., an eternally appreciating housing market). This has all convinced me that the ratings agencies' optimistic ratings were a symptom of the problem, and not a cause of the crisis brought on by lack of regulation of the agencies.
(HT: Institutional Economics)
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