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Why Did the Ratings Agencies Not Do Their Job?

October 30, 2008

Arnold Kling writes about evidence of the misfeasance of the ratings agencies (Standard and Poors and Moody’s) that rated the risk of debt securities. Arnold attributes this to a divide between the "suits and the geeks." Perhaps, but that doesn’t explain why the divide persisted in the face of market incentives to bridge it.

I find the failure of the ratings agencies to be pretty hard to explain. As private market actors unconstrained by regulatory dictates on how they did ratings, I would have thought that a more sophisticated system for rating risk would have evolved. Apparently it did not and the ratings agencies were effectively captured by the rated entities.

I would have thought that such capture would have seriously degraded their value to the market– perhaps being used only to check a box with respect to a rating required by other financial regulations (e.g., with respect to assets held by a bank). However, from what I have read, unregulated investors actually relied on the substance of the ratings.

Why they did so in the face of evidence of capture is mysterious. Do we just chalk it up to a bubble mentality?

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