January 24, 2017

Since the Recession, Have We Learned Our Lesson on Bond Ratings?

Bruce Yandle

Distinguished Adjunct Fellow
Summary

Market competition may not put everyone's mind at ease when comes to buying fresh meat, tomatoes and mortgage-backed securities, but it still helps.

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It took more than a decade, but in mid-January, the Justice Department accepted settlement of an $864 million suit brought against Moody's, an iconic bond-rating service, for illegal activities involving the 2008 credit meltdown. Most of us associate the firm's name with labels like AAA ratings found on corporate and government bonds. A $1.5 billion settlement had been struck earlier with Standard & Poor's for similar charges, another major rating service. Fitch Ratings, a third rating service, was not the subject of a suit.

Moody's and S&P had fallen from grace. They were found to have misled investors worldwide, and in doing so laid stepping stones in the path that led to the credit market meltdown and Great Recession that followed. It took 10 years to get the settlement, but they had to pay.

Until the 2008 credit market meltdown, credit ratings by Moody's and Standard & Poor's were viewed in the same way as government imprints we see on fresh beef in the supermarket. If the sticker says "USDA Prime," we have no doubt that the meat has been inspected, is good stuff, and safe for our family.

But think for a moment. If suddenly there was no federal meat inspection service, would we be thrown to the wolves and no longer feel safe when buying fresh meat? Or would Publix, Wal-Mart, Whole Foods and the many other food purveyors double-down and assure us that we would not be poisoned by food purchased in their stores? Can competition deliver high-quality food?

Before saying no, think again. Is there an inspection service for fresh produce? Do we feel the fresh cucumbers and tomatoes we buy are generally safe for our families? I think so.

But the trust accorded Moody's, as well as Standard & Poor's, by global investors was shaken when they learned that the rating agencies had given high ratings to bonds backed by low-quality mortgages. They carelessly mislabeled their clients' financial paper. They knew their clients preferred good ratings to bad ones. The good rating enhanced the ability of the large banks and brokers to sell securities in global markets.

But then, as Warren Buffet puts it: You can't tell who is swimming naked till the tide goes out. Things went swimmingly until interest rates went up. Higher interest rates led to defaults on the sub-prime mortgages that partly backed the mislabeled mortgage-backed securities. And then the house of cards started to tumble, worldwide.

It was a case of lost trust.

But if competition seems to work in bringing safe tomatoes and other produce to market, why did it fail with rating firms in 2008? At the time, there were just three government-approved rating firms, and the entry of new competitors faced high regulatory barriers. The incumbent firms enjoyed non-contested markets. They could be a bit more relaxed when favoring the clients over consumers in pursuit of profits.

What about now? Did we learn from the sad rating-firm experience and alter the way rating markets work?

In a word, yes. Instead of just three government-approved rating firms, in December 2015 there were 10. While Moody's and S&P still enjoy the lion's share of the market, they know that competitors are expanding market share. Market competition may not put everyone's mind at ease when comes to buying fresh meat, tomatoes and mortgage-backed securities, but it still helps.