Why are the Bond Rating Agencies Still in Business?

If there are clearly identifiable villians in the sub-prime mortgage fiasco, it is the bond rating agencies. The idea of securitization is that the market can price and bear certain kinds of risk better than institutions. The Pithlord continues to believe that this is so, and therefore that securitization will rise again.

But the Pithlord's faith depends on honest intermediaries giving the straight goods about what the risks are. Moody's and Standard & Poor notoriously failed to do so. They didn't distinguish between diversifiable risk and non-diversifiable risk, and therefore gave collections of crappy mortgages much higher ratings than they deserved. And they were in a conflict-of-interest, since their revenues depended on sales. At the height of the bubble, the market was happy to be suckered.

So why, asks Matthew Yglesias, are these same agencies still around:

One of the bolder libertarian contentions out there is that the world could do without the function that’s performed by the Consumer Products Safety Commission. After all, the logic goes, consumers want to buy safe goods. This means that producers want to be able to credibly signal the safety of their goods. That means that there ought to be, in a CPSC-free world, a market opportunity for a firms that rate the safety of consumer products. Toaster makers would hire toaster-inspectors, and ask them to give the toasters a clean bill of health. “That’s crazy,” you might say, “who would trust a toaster-rater who was getting paid by the toaster-makers?” But the answer is clear. A toaster-rating agency needs to have a strong, credible brand to be valuable to toaster-makers. Getting a seal of approval from a toaster-rating agency that’s known to cook the books in exchange for business would be worthless. So toaster-raters should stay honest, and those who aren’t honest should find themselves out of business.

Now as it happens, we don’t handle consumer product safety like that. But we do handle bond rating that way. But there are only three ratings agencies. And as it happens, during the late boom years all three acted corruptly. So instead of losing credibility and going out of business, all three are still in business. And when you think about it, something similar happened with the big accounting firms during the Enron bust.

Yglesias' account of the Enron scandal is a bit misguided - after all, Andersen did go broke as a direct result. This was pretty rough justice, since the Big Five were probably equally guilty, but it did have an effect on the other four. They leavened their 1990s-style "innovation" with a bit more risk aversion - at least for a few years.

So why was there nothing like the bankruptcy of Andersen as a result of the CDO debacle? Doesn't this genuinely create a problem for those of us who think markets usually work better than regulators?