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August 1st, 2013
The lead article in today’s New York Times, “Banks Find S.&P. More Favorable in Bond Ratings,” shows why the financial sector needs regulation and oversight — because without it, the imperative to earn more money takes effect, often with deleterious consequences.
The issue in this article involves what ratings agency a bank will choose to rate the financial packages it offers to investors. Banks acting solely in their self-interest will tend to choose the agency that will provide the best rating. The three main rating agencies, S&P, Moody’s and Fitch, compete with each other to get bank contracts, and any agency with a reputation for higher ratings will tend to get more business.
It’s not rocket science, but it’s what led to the bubble and financial crisis that nearly took down the world economy. Ratings agencies gave inflated analyses of subprime residential mortgage derivatives, and when investors realized this, it caused a panic … and the rest is history.
In the wake of this crisis, S&P toughened up its ratings requirements, but that wasn’t very good for business. So last September, S&P adjusted its criteria in order to generate better ratings, and it seems to have succeeded. Now, we may be dealing with commercial mortgages, but the concept is the same.
It’s uncertain whether this story in The New York Times will generate any clamor for reform, but we can only hope.
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