Monday, March 16, 2009

Pay To Not Play

While I'm on a roll, and encountering subjects about which I know something. Ratings. Those little letter grades you find attached to bonds, and which have not been amazingly good predictors of how safe the bonds are.

San Diego Law's Frank Partnoy, the nearest thing academia has to a ratings expert (Duke Law's Stephen Schwarcz comes close) has an op-ed out asking why we're still dependent on ratings agencies, even after they failed us so badly. Partnoy says, quite rightly, that ratings are much too entwined right now in the corpus of financial markets regulation.

All good. And then he gets here:

The financial markets can function without letter ratings. Instead of relying on arbitrary letters, regulators and investors should consider all of the information available about an investment, including market prices.

Finally, regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.

Which is sort of like wishing that all financial regulators were unicorns. I don't doubt that this novel "judgment" substance he speaks so highly of can be bought in by firms and regulators. But this has a price, and it will need to be passed on to market participants somehow. The hiring of large numbers of buy-side analysts will add appreciably to the fees charged by money-market funds. The hiring of more and smarter regulators will similarly be borne either by some kind of investor insurance scheme or by tax-payers. It may also, and you may think that this is a feature rather than a bug, restrict the types of debt securities that are available to all but the richest and most risk-thirsty private individuals.

These developments could all be desirable. I've got more skeptical of late abut the ratings' agencies arguments that they're the only hassle-free game in town. I am, like many people, now convinced that opaque debt markets were a sufficiently major cause of the crisis that the additional expense of an overhaul is now necessary. And I'm one of the agencies' water-carriers. But a huge cost there will be. We can't pretend that putting on a tough face will be enough.


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