Linkmeister

The Big Short

I finished reading Michael Lewis's The Big Short the other day. It succeeded in worrying me greatly, because until today nobody on Wall Street has appeared to get the message that their misbehavior and stupidity in causing the worst recession since the 1930s should be punished.

That's fine and I hope it works, but the ratings agencies (Moody's, S&P, and Fitch) should also be put under the microscope. The way those firms are compensated (the issuer of the security pays them) creates a conflict of interest. Here's how:

If Goldman Sachs wants to issue a security made up of millions of lousy mortgages, it goes to one of the agencies to get that security rated. It pays for that service. Goldman wants the highest rating possible in order to make the security as attractive as possible to its customers, who are typically institutions like pension funds and mutual funds. If the agency finds that the security isn't worthy of the highest rating, Goldman could simply take its business to one of the other agencies in order to get that high rating. Unless all the agencies colluded, they could be played against one another. Goldman could say "Moody's, unless we get the highest rating we're going to take our business over to S&P; since you're paid for each security and we issue a zillion per year, that's a ton of fee revenue you'd lose unless you do what we want."

The obvious solution is to change the method of compensation the ratings agencies receive. I don't know whether it would make sense for the government to contract with them to rate securities, but at least that would put a middleman between the issuers and the agencies. If it was done that way, the agencies would have to be objective or face the loss of the contract.

Posted by Linkmeister at April 16, 2010 02:57 PM | TrackBack