Pearls of Wisdom: Who is Being Regulated?

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One of the causes of the 2008 financial crisis was the high demand for securities backed by sub-prime mortgages and rated triple-A (AAA) by the rating agencies. The agencies gave the AAA rating to many bonds that turned out to be much riskier than the rating implied. The demand for those bonds, driven in part by the ratings, was the main driver of the issuance of sub-prime mortgages to homeowners — creating the bubble. The discovery that the bonds were more risky than people thought precipitated the sharp drop when the bubble burst.

Part of the problem is that the rating agencies have a conflict of interest. The agencies are hired by the investment bankers who are doing the deals — not by the investors who use the ratings to help make decisions!

Congress previously passed a law (Credit Rating Agency Reform Act) which specifically exempted the actual rating decision making process from regulation. The logic was that many thousands of Americans are employed by the rating agencies and by the investment banks, and the law firms and investment companies, and that restricting the ratings could end the bubble and put all of those jobs at risk. There was some truth to that — executing the financial crisis did employ thousands of people — and those thousands were much more vocal in the halls of congress than were the millions whose savings were being put at risk.

Now, the House Financial Service Committee just approved a new law sponsored by Ann Wagner (Republican-MO) to give the rating agencies new power to sue the SEC for over-regulating them.

I donโ€™t think I missed a populist groundswell demanding that the rating agencies be given more power to fend off regulators, but apparently that is the message that some of the leaders of our Congress got.

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