Here's a fascinating and long overdue discussion of the role the credit ratings agencies have had in our recent financial meltdown, between two economists at Brown, Glenn Loury and Ross Levine. They are primarily discussing Levine's new paper on the roots of the crisis, entitled: An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide?
The whole thing is well worth the time to watch (and read), but the nut is that those agencies (Moody's and Standard & Poor's) were chosen in the mid seventies by the SEC to assess risk for the financial markets, and given the support of the SEC for doing so. Shortly thereafter, bank examiners, the Federal Reserve, insurance regulators, and foreign banks' regulatory agencies also farmed out the risk assessments to those same agencies.
At the same time, the compensation scheme for the agencies changed - before that era, investors paid the agencies for rating the quality of the investments, but after receiving the official imprimatur of the SEC, the Fed, and other agencies, they began to be paid by the issuers of the securities they rated.
It apparently didn't occur to the regulatory bodies that they were building a huge conflict of interest into the system, and then trusting the health of the entire system to the fox they'd hired to watch the chickens, and in fact, the fox didn't start eating chicken right away. It took the development of the alphabet soup of "structured financial assets" (MBSs, CDOs, CDSs, etc., etc.) for cheating to become so lucrative as to become irresistible. At that point, the ratings agencies began collecting consulting fees for advising investment banks and mortgage brokers about how to structure a security in such a way as to make it possible for the ratings agency to give it a good rating, and then charging the same issuers to rate the securities they had just helped structure.
Meanwhile, the various regulatory bodies had become pretty much completely captured by the industry they were supposed to be regulating, so they had no reason to notice that the interests of the credit agencies was even more conflicted. The agencies did serve one purpose, though - when the system melted down, all the rest of the thieves were able to absolve themselves of responsibility for their malfeasance by pointing their fingers at the ratings agencies "...But they were all AAA-rated bonds!"
The kicker is that before the credit ratings agencies got their special status in the 1970s, various academic studies showed that they weren't all that great at assessing risk - usually, about 18 months behind the market. Doesn't look like adding massive conflict of interest to their burdens made them any better at it, so ya gotta wonder why a financial system that knew the agencies were likely to be 18 months behind might have decided to entrust their financial well-being to those ratings...
...or maybe you really don't.
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