Tuesday, February 26, 2008

Unintended Consequences in bond market regulation

in today's WSJ:

What happens when the feds license only a few companies to provide a service, and then require investors to buy that service?

For the answer, take a look at the mess in today's bond market, where investors have been hanging on whether the main government-appointed credit rating agencies -- Standard and Poor's and Moody's -- would downgrade bond insurers MBIA and Ambac. Equities rallied yesterday when the agencies maintained their AAA ratings.

By now no one should care what the rating agencies think, but the problem is that by law we have to care. Since 1975, the Securities and Exchange Commission has limited competition in the market for credit ratings by anointing only certain firms as "Nationally Recognized Statistical Rating Organizations" (NRSROs). A 2006 law has begun to lead to faster approvals of new entrants, but this follows decades of protection for the incumbent firms.

Over time, federal and state laws and regulations have explicitly required NRSRO-rated securities to be held by money market funds, insurers and others. This in turn has created the impression that these ratings are something more than merely financial opinions, which are often less informed than opinions you can read in a newspaper. Every state and federal legislator eager to avoid a repetition of the subprime crisis should begin excising the term NRSRO from statutes and regulations.

This process has begun at the SEC.

Not surprisingly, the rating agencies are coming up with their own ideas for "reform," none of which seem to include more competition. In its 27-point proposal, S&P suggests more training for its analysts, better review of analytical models, and better disclosure of a security's collateral -- all welcome changes, but remember that Moody's and S&P also suggested reforms after the Enron rating debacle.

No doubt S&P and Moody's would love Congress to add rules that raise the cost of entry for new competitors. If Congress takes this bait, it will repeat the mistakes of Sarbanes-Oxley. "Reform" of the accounting industry ended up being a gold mine for the very auditing firms that Congress wanted to punish, as a few megafirms thrive in a more regulated market. The key to better ratings is for Congress to make the rating agencies compete in a market where no one is required to hire them.

UPDATE: Jesse Eisinger and Felix Salmon have more:
Why did Moody's do all that work over ten years to come up with the muni/corporate ratings equivalence and not move munis onto the regular scale? When I asked Moody's they said that the market likes to have fine distinctions in their muni ratings. Ok, so why does muni bond insurance need to exist, which makes every insured bond Triple A? Because, Moody's told me, the market likes the "commoditization" in the ratings that bond insurance brings. Hmmm. So which is it?
Previous UC installment here.

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