Passing the Buck

Credit CardThe New York Times reports as the largest pension fund in the country, the California Public Employees Retirement System (CalPERS) sues credit rating agencies for forcing them to make risky investment decisions and ignore the potential for a market down-turn. Oh, no wait. That’s not an accurate description of the events that transpired at all.

CalPERS is accusing the three leading credit agencies in the US of giving positive reports to risky assets, which results in losses to the fund of over $1 billion over two years. They claim that there was significant conflict of interest: the ratings agencies were being paid by the financial firms to give their instruments and packages ratings. Surely there was less money for them if they were pessimistic about the assets being offered?

That’s just not true. But remember that if there was a market system in place, no such conflict would arise. The ratings agencies wouldn’t be able to offer bogus ratings, because if they did so they would lose market share. The reality is that regulation from the Securities and Exchanges Commission (SEC) prevents any real competition between credit rating agencies.

They hold a captive market. If you want to sell anything to investors, you need to go to the same firms. Nobody was in danger of losing business if they didn’t rate them well, so there’s no incentives for innovation in ratings processes. It’s no wonder that the private investment firms were able to come up with new instruments faster than the credit rating agencies could gauge their risk.

So regardless of appearances, firms weren’t controlling the credit rating agencies. Or even if there was some corruption, that ignores the sine qua non: government regulation of the credit rating framework. In a free market, the consumer is king because he has choice. Not so with the information from credit rating agencies. Consumers couldn’t punish bad credit rating agencies because they had no-one else to turn to.

Of course, the question asked by the New York Times is whether the credit rating agencies are in any way liable for the damages suffered by the CalPERS fund. Just as CalPERS are passing the financial burden onto future tax-payers with their exorbitant defined benefit scheme, so they are also passing the blame onto someone else as well.

CalPERS now admit that they had no knowledge of the contents of the securities that they were investing hundreds of millions of dollars in, as though this makes them not culpable for not recognising the risk. Why would they, when any shortfall in their investment return was going to be covered by tax-payers?

That’s the real source of their problems. Lack of financial accountability was inevitably going to lead to a lack of moral accountability. But regardless of who they are and what they were looking for, CalPERS should have known that they were taking a risk with the securities (and the down-turn isn’t evidence that it was a bad rating, just that the risk didn’t pay off).

Regulation cannot replace the individual looking out for his own interests. If credit rating agencies are punished, it’s no better than lenders in dodgy banks getting their money back when it goes under. Until investors suffer the consequences for their negligence and are substantively blamed, they will never take responsibility for themselves.

The culture of consumer as victim being exploited by investment opportunity benefits no-one, and creates moral hazard. CalPERS need to be punished. If only it were possible to punish their charges as well.

© The Free Marketeer 2009

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