Sunday, January 25, 2009

The New York Times

A front page story in today's New York Times, by Stephen Labaton, onthe basis of "recent interviews with officials" and statements at the incoming crowd's confirmation hearings, tells us that the new administration will "move quickly to tighten the nation's financial regulatory system."

Both Mary Schapiro and Timothy Geithner -- the new heads of the SEC and the Treasury Department respectively -- say for example that they want to change the compensation model of credit rating agencies.

I'll link you to what I said about this issue in October in my other blog. If you don't feel like chasing that link, here's an incentive. Cows are involved.

But if even that incentive leaves you unmoved, here's the crucial (non-bovine) paragraph:

There is a powerful case to be made that the credit rating agencies have had an inherently conflict-prone business model, and that this has introduced an element of instability into the US financial system in recent years. In short, they're paid by the issuers they rate. If they rate an issuer's garbage AAA, that issuer will presumably give them repeat business. If they downgrade, the issuer has had the option of shopping around for a higher rating elsewhere. So there's been a race to the bottom, and anyone can get a AAA.

My own instinct, when faced with a perverse incentive structure of that sort, is to ask not "how soon can we get the government to prohibit this?" but raher, "what has the government done to encourage/empower this?"

In ther case of the CRAs and their compensation model, there are good answers to the latter question. But I don't like to become too predictable, so I won't pursue that. Consider it your homework assignment, dear reader.

Instead, I'd just like to point out in a cynical spirit that S&P and Moody's could strike back were they to feel really threatened by any regulatory change. They could lower the credit rating of US Treasury bonds. How devastating would that be to the ability of the US to keep borrowing on a world-historically absurd scale.

Mutual assured destruction. Just like the old Cold War.

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