Learning from the Collapse from the People Who Saw It Coming

With a new Administration in the wings, and the financial crisis, if not resolved, somehow moving into a state where we can think about something besides today's Dow Jones, thought leaders are starting to emerge with suggestions on lessons learned and what to fix.  Some of the most interesting come from people who saw this coming from long ago.  The New York Times ran a front-page article reviewing Moody's involvement in the crisis, you can see it here.  She quotes a Moody's alumnus, Tom McGuire, but fails to mention his amazingly prescient speech in 1995 when he basically told the SEC that this was going to happen.  You can read the full document on Moody's web site here (you'll need to register, but the article is free).  Here are some excerpts, if you react like I did, you'll get the chills:

What I am talking about is the appropriation by governmental authorities, such as the people sitting in this audience, of ratings for use as instruments of financial market regulation. Why is this a problem? Because, like a cancer, it slowly and silently kills the natural defenses the rating agencies need to protect themselves against the economic leverage of issuers on their rating decisions. By using securities ratings as a tool of regulation, governments fundamentally change the nature of the product agencies sell. Issuers then pay rating fees to purchase, not credibility with the investor community, but a license from a government. As a result, officially-recognized rating agencies have a product to sell even when they fail to maintain credibility with the investor community. The natural check against the weight of issuer fees has disappeared. Government regulation has inadvertently created a cancer which is killing the natural defenses of the rating industry.

There you have it.  A senior executive in the ratings business telling its regulators to change course or break the ratings business.  (Full disclosure: I used to work for Moody's myself, which is how I first learned about this speech.  I had no role in the rating agency or in assigning ratings.) So that's your first step: stop financial regulators from using ratings.  Some of that is already happening, but more needs to be done.

My other favorite example comes from Professor Emanuel Derman by way of Joe Nocera, you can read it here.  Derman's modest proposal is to pay the rating agencies and investment bankers "in kind," meaning that their compensation be the securities they have rated and/or created.  This is a fabulous idea, and might do more than anything else to rebalance the industry.  Right now nobody believes ratings any more, and some markets need ratings to be credible for the market to function: so putting "your money where your mouth is" sounds like a great idea.