Partnoy on the Market Crisis, Credit Rating Agencies, and The Match King
I attended a very interesting lecture yesterday, by Frank Partnoy (USD Law), here at Thomas Jefferson Law School. There were a lot of highlights, among them these:
Frank talked a fair amount about his new book, The Match King. It discusses Ivar Krueger, the Wall Street swindler of 80 years ago whose misdeeds led directly to the 33 Act. Krueger promised steady returns; used a variety of devices to hide his Ponzi scheme; in essence, he was the Bernie Madoff of the 1920s. Frank pointed out these similarities, and showed how market crises today have many factors in common with Depression-era problems. The whole discussion was extremely interesting and topical. (The WSJ agrees, saying in its review that “the tale of the Match King holds lessons for our own day and for future generations.” Seriously, go buy The Match King today if you haven’t already — and pick up Fiasco and Infectious Greed, too, if you don’t have them.)
From there, Frank branched out into a topic you’re familiar with if you’ve read any of his work — the big problems with credit rating agencies Standard & Poor’s and Moody’s. There are a variety of reputational intermediaries used today in different markets (e.g., the USDA). Ratings agencies like Standard & Poor’s and Moody’s are seen as private entities, but Frank argued that they should in fact be seen as hybrids between government and private actors. This is because they are inextricably tied to a number of legal rules; thus, they effectively become sellers of regulatory licenses.
On a broader level, Frank argued that problems with the rating agencies underlie much of the current crisis.
The main link is that the crisis was brought on by the defaults of exotic instruments — super senior and AAA rated tranches of CDOs and synthetic CDOs. These kinds of instruments could not have existed without the ratings given to them. Those ratings allowed banks to divide the loans into tranches and thus create AAA and higher instruments. Investors like fiduciaries for pension plans, insurance companies, and banks themselves saw the AAA rating and mistakenly thought the investments were safe.
However, the rating greatly which understated the real risk and the instruments were actually nowhere near as safe as believed. (As Frank offered the same proposal in recent testimony before the SEC.)
Should the banks simply be allowed to fail? It was clear as of 2007 that most big banks were insolvent. They trade in a dream world now — stock based not on assets, but on expectation of bailout. Bondholders oppose any insolvency or nationalization, though. Right now, we’re living in denial, trying to patch it up. Meanwhile, banks have had to take possession of 10 million homes, which we have no good system for handling, and which are just rotting.
I found Frank’s talk extremely informative. I’ve read a number of analyses of the crisis in the news, but none which so clearly make the link between the CRAs and the financial crisis. It’s clear that there were many bad actions taken by different people in the crisis, and there have already been calls for changes on a variety of topics, like mortgage lending standards, executive compensation and even derivative investment generally. Frank’s analysis makes clear that, in the same breath as we talk about any other of the failures that led to the crisis, we need to talk about credit rating agency failure.