The ratings agencies deserve more of the blame

than they have been getting:

Noah Millman has a fascinating post about his initial belief in the promise of synthetic CDOs and his eventual disillusionment. Ultimately, it all comes down to what the ratings agencies were willing to let people get away with:

How did a market that, I thought, had really helped capitalism work in 2002 become the great destroyer of capitalism of the last two years? There were a lot of contributors to the catastrophe, but one indispensable one is that the ratings agencies monetized their sterling reputations in an extraordinary fashion, and nobody in regulatory apparatus of government saw that this was happening, and what it might portend. The success of 2002 depended on market confidence in the ratings agency process: that’s what made investors willing to buy the notes issued by structured finance vehicles that issued the credit protection that made it possible for banks to hedge. Without that confidence, the market would never have developed. And by 2006, the agencies understood just how much that confidence was worth. […]

Now, of course, the agencies have radically reversed course. They have completely changed their models, of course. But they’ve also begun to “follow the market”, incorporating credit derivatives swap and equity market pricing into their ratings for companies. If in 2006 the market had, to an alarming degree, delegated its risk-management to the ratings agencies, now the ratings agencies have delegated a great deal of their ratings process to the market. And so the market has lost any reason for confidence in the agencies in both directions: they cannot be trusted when the market is strong to assess the downside risks the market is ignoring, and they cannot be trusted when the market is weak to assess a company’s financial condition independently of the market panic.

I’m not really sure what we’re supposed to do about this. I’m inclined to say that if ratings agencies are going to have such an important public function we ought to have that function performed by a public agency. In practice, as soon as people went back to not wanting to pay attention to financial services regulations, I think you’d have a big regulatory capture problem. But beyond the fact that the private ratings agencies performed poorly, the fact of their poor performance doesn’t seem to opened the market to competition or new entrants or whatever it is that leaving this kind of thing in private hands is supposed to accomplish.