Occasionally he is right about something

I’m referring here to Paul Krugman’s column today.  The ratings system in the financial sector has been a complete pile of crock.  As Krugman noted, 93% of AAA-rated subprime-rated mortgage securities are now junk. How often should a AAA-security end up as junk?  Clearly there has been huge systemic failure in this area.

I’m a very cautious regulator.   One of the potential justifications for government regulation occurs if quantities and/or prices are not transparent.  Mortgage-backed securities seem to be a clear case of non-transparency.   And this non-transparency was aggravated by the corruption of the ratings’ process.

I don’t know what the best fix is, but I think the good news is that ratings should be an area where government’s role need not be huge or even terribly intrusive, even though it might end up being crucial.  Indeed, a little intervention in the ratings game might have gone a long way to avoiding the systemic failure of this part of the industry.

8 thoughts on “Occasionally he is right about something

  1. Sven, though I do not know the details (this is far beyond my field), my impression was that part of the reason the ratings agencies “morphed” into this form was earlier regulation requiring ratings <ifrom these agencies to satisfy certain collateralization or capital requirements. In other words, Congress created an oligopoly, and virtually guaranteed regulatory capture, because it did not trust market pressures on ratings information to keep them honest. “Morphed” indeed.

  2. Yeah, I don’t know the history either. I wouldn’t be surprised if you are essentially right.

    The problem with textbook theorems of when government should regulate is that it is always a high probability that government action will actually make things worse, even if there is a theoretical case for making it better.

    Then again, that in itself could be a public choice theorem–well intended regulation usually goes badly.

  3. The problem with the ratings are the ratings industry themselves — a government-induced monopoly.

    As always, the solution to regulation-caused problems is more regulation.

    1. Some people put informational asymmetries in the category of market failure. But I think this is a bit of a gray area, meaning I don’t think all informational asymmetries are market failures. And even if they do result in market failure, that doesn’t mean the government “solution” is going to be superior to the status quo.

      There are clearly lots of information asymmetries associated with the financial mess. One reason that asymmetries become market failures is that the seller cannot credibly reveal the true quality of the good. A rating agency is supposed to farm that process out to a rating agency. But that didn’t work because the raters were in cahoots with the sellers. Having each potential buyer of securities hire his/her own rater, would be impractical and very inefficient I’m guessing.

      I’m also wondering why the rating agencies didn’t place more stock in the value of their own reputation. That would be the traditional argument against government action, i.e., if people have the incentives to be truthful (such as making unbiased ratings) there shouldn’t need to be government action to make sure they are truthful. Apparently the incentives were drastically different than we had assumed. I’m not clear how.

      Sven

      So perhaps there needs to be some kind of wedge between the sellers and the raters

      1. A market is said to “fail” whenever it does not produce all possible pareto improvements. Perfect information is a technical requirement of (perfectly) efficient markets. Information asymmetry is a special case of imperfect information. That is why it is generally categorized as a “market failure.”

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