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Congressmen Have Some Advice For Ratings Agencies

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The ideal financial regulatory regime would go like this:

  • Regulators would tell market participants not to screw up.
  • Market participants would not screw up.
  • Peace and harmony would reign throughout the land.

This is ideal not only because of the peace and harmony but also because it omits any work by the regulators. Why choose whether to set capital ratios based on risk-weighted or total assets when you can just tell banks not to lose any money? If they never lose money then it doesn't matter how thinly capitalized they are.

These guys know what I'm talking about:

U.S. lawmakers have written to three credit-rating firms with a warning: Don't misjudge the risks of so-called synthetic CDOs if the market for such deals takes off again.

"It is vitally important that you get it right this time around," wrote U.S. Reps. Peter Welch (D., Vt.), Luis Gutierrez (D., Ill.) and Keith Ellison (D., Minn.) in a letter Tuesday to Standard & Poor's Ratings Services, Fitch Ratings and Moody's Corp., the parent company of Moody's Investors Service. ... The lawmakers say in their letter that, if those deals were completed and rated, the rating agencies have a public duty to make sure the transactions aren't given overly rosy grades.

In an interview, Rep. Welch said, "We don't want history to repeat itself, and the history is that the rating agencies aided and abetted the big banks in giving sweetheart ratings" to structured finance deals. Ratings firms have been criticized for offering high marks to deals issued by companies that pay to receive ratings.

I imagine Welch, Gutierrez and Ellison holed up in an office somewhere sequentially SOLVING ALL THE WORLD'S PROBLEMS. "Ratings agencies? Check. Now let's write to Jamie Dimon and tell him that it is vitally important that he never ever let traders lose $6 billion dollars again. This financial regulatory stuff is EASY!"

I mean! To be fair, if there's anyone who could benefit from a letter saying "maybe try to get the right answer this time instead of the wrong one," it's the ratings agencies. They've probably heard that one a few times by now but a little repetition can't hurt.

But really if your concern is "ratings agencies are a bunch of inept goons and their ratings are vitally important for public safety," the right approach is not to send them a letter saying "stop being inept goons." Inept goons can't read. Improving them is hard. Decoupling their ratings from "vitally important for public safety" is ... I mean, is also quite hard, but is doable. By Congress. Congress can make ratings less important, by doing things like rewriting laws and regulations to remove reliance on ratings. That is a thing that it's trying to do.

And a thing that has had some success? The synthetic CDO revival that sparked this letter didn't actually happen, rendering the ratings agencies' synthetic CDO ratings prowess or prowesslessness irrelevant. Somecommentators took this as a reason to celebrate the market's essential good sense and refusal to buy crap just because it comes with an AAA label. Others took it as a reason to celebrate1 the essential good sense of the regulatory response to the last crisis:

I believe Yglesias also misdiagnoses the main reason these deals no longer work. Apparently he thinks that buyers, particularly the senior/super-senior protection sellers, have suddenly gotten wise and learned their lesson, having been so burned in the past. Perhaps that’s part of investor reluctance/skittishness, but I have to think far more operative here are the punitive capital requirements that everyone knows these deals attract now and going forward, as well as rating-agencies having revised their models.2 As a result the arb that let everyone push this sort of risk over to AIG Financial Products-London (let alone into some levered super-senior vehicle) is no longer quite there, and without that, the fact that there never really were any ‘natural buyers’ of the senior-tranche risk can be finally revealed and let itself play out in the right way (deals that fundamentally shouldn’t be workable and wouldn’t be workable without arbable regulation, aren’t struck).

That is: if capital regulation no longer ascribes a 20% risk weight to a AAA CDO tranche, and if systemic-risk regulators keep track of the AIG-FPs of the world as well as the banks, then it's no longer "vitally important" that AAA CDO tranches be properly rated. I mean, it'd be nice. But the fate of the world no longer rests on the ratings agencies' bovine shoulders.

If ratings agencies "have a public duty" to get ratings right, and sometimes get ratings wrong, telling them to try harder is, like, at best a fourth-best solution. Making it not a public duty seems more promising. And seems to be working.

Lawmakers Warn Ratings Firms About New Debt Products [WSJ]

1.You may interpret the tone of that post as other than celebratory, which is your right.

2.Which does go to ratings-agency competence / lack thereof, but which also suggests that the Welch/Gutierrez/Ellison letter was unnecessary. They'd already decided to get it right! Or whatever.