What's Wrong with Bond Ratings

There has been much talk in recent months about how bond rating agencies are at least partially to blame for the economic crisis. The argument is that these agencies have granted AAA bond ratings to bonds that belong on the junk pile, thus encouraging folks to take risks that they really should have avoided and inflating asset prices to unreasonable levels. Maybe that argument is sound and maybe it isn't, however there is something clearly wrong with the way bond ratings work and here it is: bond ratings are paid for by the sellers of bonds...

Yup, that's right. The good people who rate bonds get paid by the very people who stand to gain most from a favorable bond rating. This is so absurd that it boggles the mind and it goes back to my own thesis about the cause of the economic crisis: misaligned financial incentives. If you are buying a house, would you consider having the seller pick and pay for the home inspector? If you intend to sue someone, would you feel your interests are served if the defendant chooses the judge and pays for his salary? How about when you buy a used car. Would you feel comfortable taking the recommendation of the seller's mechanic? I sure wouldn't.

And yet, bond rating agencies are paid by the very people whose bonds they are required to rate. Since bond issuers get to pick their own rating agency, do you think rating agencies would risk losing business by protecting the interests of bond buyers rather than the interests of the ones who pay their bills? I don't think so.

Now here's where it gets REALLY fun. Last week I was listening to an NPR radio news item and heard the head of this or that rating agency describe his bond ratings as "the world's shortest editorial", thereby trying to invoke the first amendment and turn his agency's ratings into protected speech... how about that for a good deal? Give bullsh** recommendations, get paid princely sums for your supposedly objective statements, and make sure that investors who relied upon your due diligence cannot sue because all you did was express an opinion which is protected by the constitution... give me a break.

I'll get off my soap box now, but here's one good way in which the risk for future financial crises can be diminished: align the economic interests of all participants in the market. Make sure that the ones who are supposed to be honest brokers are indeed honest brokers, and those that are supposed to be neutral evaluators do not have a financial stake in the end result. It just seems like common sense, no?

As a complete aside, the same case can be made against political contributions by corporations, institutions and large private donors. While our politicians have an economic interest in listening to the special interests who fund their campaigns, we will never be able to get decent work out of Congress.

Here are a couple of other interesting posts about the economy:

All Financial Matters brings up a timely item: how can the administration tell how many jobs it is saving through the stimulus spending, if any? Yeah well, it can't. It's all about political parties and pundits playing the political game and looking for an edge. The better question to ask is, "are they doing the right thing". By and large, I think that the answer is "yes".

Frugal of My First Million has a gloomy view of the economy and complains about financial institutions paying back TARP money to escape government regulation of their compensation plans. I don't share his opinion about the banks. I think they are in a hurry to get out of TARP because Congress has changed the rules on them after they got into the program. And please remember that the government literally FORCED some of these institutions to take TARP money. On the other hand, it's too true that many of these institutions would have failed without the government. It's a difficult problem, but I for one think that the faster the government gets out of private sector business ownership, the better...

Finally, check out this post from Weakonomics about how credit card companies make money.

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