After the collapse of socialism, the elite support free enterprise – they support it the way they support free speech.
If anyone is allowed to disagree with the orthodoxy taught at Yale and Harvard, or even doubt it, this endangers the free speech of people from Harvard and Yale, and similarly if any enterprise run by people from Harvard or Yale could go bust, this endangers the free enterprise of people from Harvard and Yale.
Basel II is tens of thousands of pages of regulations, no one knows how vast it is, because not all the regulations can be found in any one place, but it could all be replaced by two simple rules: Politically correct victim groups shall always find it easy to borrow money, regardless of their ability or intention to pay it back, and politically well connected businesses shall always make money, regardless of whether they are competently run or not.
The seeds of the crisis were the CRA and the ratings agencies. I have discussed the CRA at length, but the CRA would have been resisted had it not been for other changes in the system that insulated the players against the consequences of making bad loans. These changes, guaranteeing that badly run businesses would succeed, started with the bailout of the ratings agencies in the seventies, forty years ago.
Back then, the ratings agencies were in trouble, because they had made a lot of bad calls. It seemed that whenever an institution was going under, the guys at the credit rating agencies were the last to know about it. Back then, they sold their assessments of credit risk to subscribers. So no one wanted to subscribe.
So in the seventies, the regulators stepped in to make people use the credit rating services. In 1975 the SEC created the Nationally Recognized Statistical Rating Organization (NRSRO) designation. Credit rating agencies so designated received what was in effect a grant of governmental power. The SEC then relied on the NRSRO’s credit risk assessment in establishing capital requirements on SEC-regulated financial institutions – which meant that for SEC-regulated financial institutions to borrow and lend, they had to get rated. A cascade of regulatory decisions followed over the years, each decision forcing more and more reliance on the risk assessments issued by these demonstrably incompetent institutions – and less and less reliance on other people’s risk assessment. For more and more organizations, it became illegal for them to make their own judgments about risk.
By the 1990s, as Levine and Partnoy tell us, the NRSROs were not selling assessments of credit risks, but licenses to issue securities. The rating agencies did not genuinely assess risk, nor did anyone really expect them to. Nor could repeatedly demonstrated incompetence reduce demand for their services, so the ratings agencies had no incentive to provide correct credit ratings. Since their income was entirely dependent on the state granting them power, they did, however, have an incentive to make politically correct credit ratings. If you lend to the poor, the oppressed, etc, and you are run by good old boys from Yale and Harvard, and you make donations to the right politicians, the NRSROs have a very powerful incentive to give you a good credit rating. And if you have a good credit rating, you can borrow as much as you like – and if you go bust, the government will bail you out.
Badly run companies that had been empowered to borrow as much as they pleased got in trouble – and were bailed out for the same reasons as they had been empowered to borrow as much as they pleased.
In addition to corruptly favorably rating the politically correct, the NRSROs corruptly favorably rated those who simply gave them money, which is perhaps what those who complain about “deregulation” have in mind. The banks creating structured financial products would first pay the rating agencies for “guidance” on how to package the securities to get high ratings and then pay the rating agencies to rate the resultant products – a glaring conflict of interest, though one less apt to lead to bailouts when the proverbial hits the fan.
Now since all this dirty dealing has cost the taxpayer trillions, you may well ask what measures have been taken to punish the NRSROs for bad conduct, or give them incentives for better conduct in future, or indeed restrain them from continuing to do this stuff?
All the strengthened regulation is regulation to make people continue to treat NRSRO ratings as true, even though it has become horrifyingly apparent that the ratings are generally false. All the strengthened regulation is more of what caused this mess in the first place. Any real reform would necessarily start by abolishing the legal privilege of NRSROs, would have to start by rolling back regulations to what they were in 1974. Instead, compulsion and bailouts are being applied to make NRSRO ratings true, or to enable people to continue pretend that they are true. Their power has been increased, their misconduct unpunished, and their incentives have become even worse.
