Friday, March 27, 2009

Regulations and Ratings

The real problem was that there wasn't enough data for the Ratings Agencies to make ANY determination for the credit worthiness of these securities. The Agencies had decades worth of data that allowed them to rate corporate and governmental bonds with at least some semblance of accuracy. However, the new stuff was too new to have enough data on.

A honest assessment would have been to say that no rating could be given on any of these new products since the data needed to make a fair rating did not exist. Instead, new models based on in-house theories were created just so that ratings could be generated. Of course these model, devoid of real data and real tests, failed.

Another honest assessment would blame the regulations ALREADY in place for making ratings such an important factor in firms' capital requirements. REGULATIONS treated AAA rated bonds differently for capital requirements, they also restricted purchases by certain institutions to only investment grade bonds and such. Furthermore, competition was essentially eliminated as only a few approved agencies were allowed to make these all important ratings.

For those who don't follow the capital markets, it should be noted that the market never treated the new AAA rated securities the same as the old school AAA rated bonds. The new AAA stuff always carried a higher interest rate, and the spread grew as the ratings dropped. An A rated security of the new type traded WELL below (it carried a higher interest rate) an A rated old-school bond.

The only people who didn't seem to get it were the regulators themselves, everyone else knew that the new securities weren't the same as the old securities. AAA did not equal AAA! However the regulators failed to pick up on the HUGE hint the markets were giving and continued to allow the new AAA stuff to be treated in the same manner as the old stuff for regulatory purposes. Had they been as wise as the "market", then they would have adjusted their regulatory requirements and we would not be in this mess today. Again, this was clearly a failure of existing REGULATIONS! REGULATIONS stated that AAA capital was to be treated differently, REGULATIONS gave banks the incentive to hold AAA securities, REGULATIONS gave monopoly power to a select group of favored agencies. Ratings agencies are able to play this game because there is no other competition, it doesn't matter if they are terrible or not as long as the good ol' boys are all equally terrible. They are also insured of business because banks and other institutions MUST get ratings for REGULATORY purposes.

Don't tell it's a lack of regulations when it was the poorly crafted regulations in place that caused this mess. And now you're telling me all we need are more of the same crappy regulations to solve the problem? Give me a break, when will you people realize that regulations hardly ever work in the manner they're supposed to? There are always unseen and unintended consequences! Yet you all pretend that government can craft a perfect regulatory system when it has never been able to in the past!

I will repeat, no matter what regulations get put into place, we will have another financial crisis sometime in the future. The government, nor any entity, has the ability to create a foolproof, perfectly working system. Are we still on the Aristotelian model of perfection that cannot possibly exist in the real world? How many thousands of years are needed for people to learn?

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