The Failure of the Credit Rating Agencies

The New York Times reports:

The trip down the dysfunctional regulatory path began after the 1929 crash, when Gustav Osterhus, an examiner at the Federal Reserve Bank of New York, proposed a system for weighting the value of a bank’s portfolio. He felt regulators needed to be able to express a portfolio’s “safety” with letter symbols.

Since then, the number of financial regulations based on ratings has skyrocketed. Money market funds can buy only bonds rated in the top two categories. Banks’ capital requirements are lower for highly rated securities. Even federal highway financing depends on credit ratings.

Over time, ratings became valuable not because of their accuracy but because they “unlock” markets; that is, they are a sort of regulatory license that allows money to flow. Moreover, institutional investors came to rely on ratings for contracts that don’t even need regulatory approval. Trillions of dollars of derivatives payments depend on ratings.

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