Given what the media talks about when it comes to recessions, you could not be blamed for mistakenly believing that the ’07 market crash, housing crisis, and overall economic contraction was ultimately caused by “corporate greed.” Many of you probably came out feeling very disturbed after watching The Big Short, just as I did. How could all of those rating agencies be so stupid? Of course! They are paid by the people who sell the very bonds that the rating agencies rate. Seems like a system with bad incentives. The rating agencies have an incentive to rate bonds well, otherwise they will lose business. Leave it to capitalism to have such a flawed incentive structure!
Except that’s not what actually happened. In classic fashion, what was labelled a result of those evil corporations was actually a result of government policy. In The Financial Crisis and the Free Market Cure, John Allison wrote in great detail on the financial crisis. One of the important things he pointed out in his book is that rating agencies like Moody’s did not always receive their revenues from the banks’ whose products they rated. In fact, as Allison points out, for years the rating agencies “had charged the buyers of the bonds for rating the bonds.” As a result, this led them to be more conservative in their rating, since, they were serving customers buying the bonds.
This all changed in the 1970s, when, in classic fashion, the government stepped in and tried to “fix” a problem. The government, namely the SEC, wanted to “expand market access to ratings,” so, they forced rating agencies to change their form of compensation. Instead of charging the buyers of the bonds, the SEC required that rating agencies charge the issuers of the bonds-the banks. Of course, as most cost-transferring goes, this move probably didn’t even change the cost to buyers of the bonds, since costs could easily be embedded in the bonds being sold. And, of course, there is the other consequence-rating agencies profit motives were now (and are still) tied to the interests of the bond issuers. This has resulted in a much less conservative rating of issued bonds, and in all likelihood led the rating agencies to rate so well the shitty mortgage bonds that banks were issuing. Although we can label the banks poor decisions as an immediate cause of the financial crisis, the ultimate cause for this specific issue is government.