Partnoy on the Market Crisis, Credit Rating Agencies, and The Match King

I attended a very interesting lecture yesterday, by Frank Partnoy (USD Law), here at Thomas Jefferson Law School. There were a lot of highlights, among them these:

Frank talked a fair amount about his new book, The Match King. It discusses Ivar Krueger, the Wall Street swindler of 80 years ago whose misdeeds led directly to the 33 Act. Krueger promised steady returns; used a variety of devices to hide his Ponzi scheme; in essence, he was the Bernie Madoff of the 1920s. Frank pointed out these similarities, and showed how market crises today have many factors in common with Depression-era problems. The whole discussion was extremely interesting and topical. (The WSJ agrees, saying in its review that “the tale of the Match King holds lessons for our own day and for future generations.” Seriously, go buy The Match King today if you haven’t already — and pick up Fiasco and Infectious Greed, too, if you don’t have them.)

From there, Frank branched out into a topic you’re familiar with if you’ve read any of his work — the big problems with credit rating agencies Standard & Poor’s and Moody’s. There are a variety of reputational intermediaries used today in different markets (e.g., the USDA). Ratings agencies like Standard & Poor’s and Moody’s are seen as private entities, but Frank argued that they should in fact be seen as hybrids between government and private actors. This is because they are inextricably tied to a number of legal rules; thus, they effectively become sellers of regulatory licenses.

On a broader level, Frank argued that problems with the rating agencies underlie much of the current crisis.


Why?

The main link is that the crisis was brought on by the defaults of exotic instruments — super senior and AAA rated tranches of CDOs and synthetic CDOs. These kinds of instruments could not have existed without the ratings given to them. Those ratings allowed banks to divide the loans into tranches and thus create AAA and higher instruments. Investors like fiduciaries for pension plans, insurance companies, and banks themselves saw the AAA rating and mistakenly thought the investments were safe.

However, the rating greatly which understated the real risk and the instruments were actually nowhere near as safe as believed. (As Frank offered the same proposal in recent testimony before the SEC.)

Should the banks simply be allowed to fail? It was clear as of 2007 that most big banks were insolvent. They trade in a dream world now — stock based not on assets, but on expectation of bailout. Bondholders oppose any insolvency or nationalization, though. Right now, we’re living in denial, trying to patch it up. Meanwhile, banks have had to take possession of 10 million homes, which we have no good system for handling, and which are just rotting.

I found Frank’s talk extremely informative. I’ve read a number of analyses of the crisis in the news, but none which so clearly make the link between the CRAs and the financial crisis. It’s clear that there were many bad actions taken by different people in the crisis, and there have already been calls for changes on a variety of topics, like mortgage lending standards, executive compensation and even derivative investment generally. Frank’s analysis makes clear that, in the same breath as we talk about any other of the failures that led to the crisis, we need to talk about credit rating agency failure.

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7 Responses

  1. Ferris says:

    Prof. Partnoy’s suggestion that liability under the securities laws be extended to rating agencies is interesting, but one wonders how disinterested it is given his extensive work as an expert witness for securities plaintiffs’ lawyers.

  2. Frank says:

    I’m an admirer of Partnoy’s work—thanks for the post. But I also think that we need to ask more fundamental questions about the role of ratings agencies and the biases they generate. Consider this argument from John Quiggin:

    “State and municipal governments are beginning to rebel against the system of discrimination under which municipal bonds get rated around six grades lower than corporate bonds of comparable quality. That’s the estimate of the agencies themselves – the reality is far worse. As the NYTimes notes, “since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings.”

    ***

    “What could replace reliance on ratings agencies? For those who want a reasonably secure guarantee against default, the best advice at present would be to restrict investments to those with an explicit guarantee from a developed-country national or state government. An obvious implication is that states would need to guarantee, or borrow on behalf of, municipalities and agencies. This is already done on a substantial scale for example by Queensland Treasury Corporation.”

    http://johnquiggin.com/index.php/archives/2008/03/08/after-the-ratings-agencies/

    What is so sad about our current system is that, far from being a Hayekian dream, we have central planning by a small group of bankers enabled by hacks like the CRAs. And the more we “deregulate,” the more powerful that group is likely to become.

  3. Russ Frandsen says:

    Kaimi, As predictable, the government regulations mandating the role of the credit rating agencies removed the agencies from the discipline of the markets,and a huge crisis developed. Yet, the true market was signaling far in advance the great problems. Follow the trading prices of the underlying securities and the market clearly foresaw the risk and priced them appropriately. Without the distortions of the government mandates, the market would have provided the appropriate information to avoid the systemic risk that actually ocurred.

  4. Kaimi, As predictable, the government regulations mandating the role of the credit rating agencies removed the agencies from the discipline of the markets,and a huge crisis developed. Yet, the true market was signaling far in advance the great problems. Follow the trading prices of the underlying securities and the market clearly foresaw the risk and priced them appropriately. Without the distortions of the government mandates, the market would have provided the appropriate information to avoid the systemic risk that actually ocurred.

  5. Tim H says:

    I might have to give the book a read. looks like good stuff