Would regulation stop the mistakes of rating agencies that contributed to the 2008 crisis?

I remember watching The Big Short and feeling great indignation at the S&P employee who told Steve Carell that rating agencies were pressured into issuing unreasonably high ratings because they were beholden to their customers. If true, this represented an unbelievable moral hazard, which is often cited as the reason for the failures of the ratings agencies–and as a reason for regulating these agencies.

However, more in-depth research and consideration reveals that this answer is incomplete and, in many ways, incorrect. Claire Hill, a law professor at the University of Minnesota Law School and director of the Institute for Law and Rationality, clearly and convincingly critiques this simplistic explanation by recognizing market influences and proposing alternate causes, which also means that if we are looking to avoid a future crisis, we need to look to alternative solutions to the regulatory measures that we currently employ. I don’t think it could be said better than she does in her abstract:

Why did rating agencies do such a bad job rating subprime securities? The conventional answer draws heavily on the fact that ratings are paid for by the issuers: Issuers could, and do, “buy” high ratings from willing sellers, the rating agencies.

The conventional answer cannot be wholly correct or even nearly so. Issuers also pay rating agencies to rate their corporate bond issues, yet very few corporate bond issues are rated AAA. If the rating agencies were selling high ratings, why weren’t high ratings sold for corporate bonds? Moreover, for some types of subprime securities, a particular rating agency’s rating was considered necessary. Where a Standard & Poor’s rating was deemed necessary by the market, why would Standard & Poor’s risk its reputation by giving a rating higher (indeed, much higher) than it knew was warranted?

Finally, and perhaps most importantly, giving AAA ratings to securities of much lower quality is something that can’t be done for long. A rating agency that becomes known for selling its high ratings will soon find that nobody will be paying anything for its ratings, high or low.

In my view, that issuers pay for ratings may have been necessary for the rating agencies to have done as bad a job as they did rating subprime securities, but it was not sufficient. Many other factors contributed, including, importantly, that rating agencies “drank the Kool-Aid.” They convinced themselves that the transaction structures could do what they were touted as being able to do: with only a thin cushion of support, produce a great quantity of high-quality securities. Rating agencies could take comfort, too, or so they thought, in the past – the successful, albeit short, recent history of subprime securitizations, and the longer history of successful mortgage securitizations.

“Issuer pays” did not so much make the rating agencies give higher ratings than they thought were warranted as it gave the agencies a “can do” mindset regarding the task at hand – to achieve the rating the issuers desired, working with them to modify the deal structures as needed. That the issuers were paying motivated the agencies to drink the Kool-Aid; having drunk the Kool-Aid, the agencies gave the ratings they did. My account casts doubt on the efficacy of many of the solutions presently being proposed and suggests some features that more efficacious solutions should have.

I very much recommend reading the full article, which gives more nuance and information about the weaknesses of proposed solutions for rating agency mistakes or malfeasance. This should also be food for thought concerning the general perspective we should have in examining “market failures,” as there are often market feedback systems that mitigate problems, and turning to regulation by reflex can cause unintended harm or even miss the mark entirely.

Reference: Hill, Claire. “Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?” University of Pittsburgh Law Review (2010): 10-18. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1582539.