What If Ratings Agencies Disappeared?

That was the question that Tyler Cowen posed to Moodys' chief economist Mark Zandi in an interview posted last week for the Big Think's "What Went Wrong" series. If you follow my writing, then you know that I would love to see investors rid themselves of their dependence on the rating agencies. Since Zandi works for Moodys, I was very interested to hear his response. I don't entirely agree.

First, let me say that I really like Zandi. I've talked to him a few times for articles, and he's good at what he does, a nice guy and quite smart. He's also one of those rare people who prefers to get things right, rather than bend himself into pretzels to fit into some political ideology. So I don't think he's just speaking the company line here, but expect that he really believes what he's saying. Still, I disagree. He replies:

I think there's a function for rating agencies because in a sense, there is a lot of despaired information and bringing it altogether is very costly and doing good analysis is difficult and you need scale to do it. Some bond houses are gaining that scale and doing that on their own. There's the PIMCO's of the world and other big bond houses that have the skill necessary to put together the staff to do the kind of analysis that needs to get done. But many other investors don't have that scale and the rating agencies, in a sense, provide that for them. And so, there are scale economies in that kind of analysis and in a sense the rating agencies provide that.

Also, there's a lot more esoteric kinds of bonds and securities that are issued and it always will makes sense to have, I think, something like a rating agency providing an opinion as to the quality of that particular bond or that security. So, I think there's an economic reason for rating agencies, so I think they will always be around, obviously the role is going to change as a result of events, but I think there will always be a role for them.

I see things differently for two reasons.

First, how about the stock market? There's plenty of information to analyze when evaluating a stock, but investors do that without an over-reliance on rating agencies. For that matter, banks and investment houses could develop fixed income research teams for bonds that serve a purpose similar to the equity research groups that exist today to look at stocks. That would provide a diverse spectrum of ideas, rather than a government-sponsored oligopoly of agencies charged with this task.

Second, maybe it's good that full analyses of complex bonds are costly. I don't know about you, but I think that there were entirely too many mortgage-backed securities in the market during the housing boom. Maybe if investors had to bear the cost involved with doing the analysis themselves, they would have been a little less eager to scoop up those bonds. Maybe then, demand for MBS would have been more restrained. Consequently, there would have been far fewer mortgage originations. The housing bubble might not have been nearly as severe, and we would have saved ourselves from a lot of trouble.

The point is that complex securities should be costly. When a market has a staggering demand for complexity, then there's probably a market failure lurking in the shadows, particularly when investors aren't doing the work. By having a few rating agencies that claim to understand these puzzling products, and the market accepting their declarations as gospel, investors will fail to assign the right cost to abstruse bonds. I think the market would ultimately benefit from a complexity premium.