The first most substantial subject missing from the debate over how to overhaul Wall Street is how to address the fucked up incentives of its biggest enablers – the ratings agencies.
Writing in The New York Times, economist Paul Krugman explains that:
The rating agencies began as market researchers, selling assessments of corporate debt to people considering whether to buy that debt. Eventually, however, they morphed into something quite different: companies that were hired by the people selling debt to give that debt a seal of approval.
Institutional investors, those entities the size of governments such as pension funds, have only bought bonds rated AAA for years. They’re not allowed to buy anything less.
While Standard & Poors and Moodys are the two biggest operations, issuers of debt can choose between various ratings agencies and give their business to whomever will give them the highest rating. You can see where this led – Wall St firms selling securities by slicing and dicing claims on things like subprime mortgages with other higher quality debt, and during the process of mixing up the CCC rated products with the AAA rated products turning them all into AAA. Brilliant really.
During the course of its investigations the Senate subcommittee has uncovered damming evidence of the ratings agencies massaging the numbers to please clients and win (or keep) their business.
These inaccurate ratings meant the financial system took on far, far more risk than most people realized at the time. Krugman points us to
Paul McCulley of Pimco, the bond investor (who coined the term “shadow banks” for the unregulated institutions at the heart of the crisis), recently described it this way: “the explosive growth of shadow banking was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out fake IDs.”
But the only provision before the Senate that may make any difference at all is one that would make it easier to sue the agencies if they engage in “knowing or reckless fraud.” This is hardly the fundamental realigning of the ratings agencies’ interests one would think necessary given the stakes.
Krugman likes a proposal by Matthew Richardson and Lawrence White of New York University. “They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.”
It could work I guess, but I have yet to hear of any other options being discussed.
Whatever happens, it’s easy to be far too optimistic about the power of regulation to prevent another financial catastrophe once and for all. Writing in The Washington Post, columnist Robert Samuelson warns that “History counsels caution. Every financial reform, even if mostly successful, ultimately gives way to another because there are unintended consequences or unforeseen problems.”
Sheila Bair, the head of the Federal Deposit Insurance Corp., has noted that the reforms of the early 1990s, which curbed risk-taking within the banking system, perversely shifted lending to the largely unregulated “shadow banking system” – mortgage brokers, specialized lenders and “securitization.”
By definition panics are unforeseeable; it’s all too easy for regulators to fight the last war. It’s quite plausible that the next financial panic is caused by say, runaway federal debt, which becomes the iceberg that guts the Titanic market of Treasury securities.
The only financial reform that has actually prevented another financial implosion was the Glass-Steagall Act of the Great Depression, which separated investment banks from depositor banks. It was eventually removed during successive waves of deregulation from the 80’s onwards until Senator Phil Gramm put the final nail in its coffin in the late 90’s. The reinstitution of that act under its new name, the Volcker Rule (named after former Chairman of the Federal Reserve Paul Volcker) would seem a no-brainer.
You would also think that higher capital requirements seem mandatory. Before Lehman imploded, banks’ capital represented about 10 percent of assets. Some would raise that as high as 15 percent, but the major side-effect of this would be reduced lending.
I remain skeptical of any regulator staffed by humans having the ability to foresee any looming crisis and be able to move swiftly enough to aver it. Which is why I favor systems rather than overseers, particularly that proposed by Harvard economist Greg Mankiw, which would require a broad class of financial institutions to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. Voila – a self regulating system.
You can compare the Republican’s new counter-proposal to Democratic Senator Chris Dodd’s bill in The Washington Independent here. I think real reform is going to come out of this process, but regardless we need to acknowledge that we cannot legislate away all risk, and nor should we try.
See also: Politico – The Wall Street-Washington Divide