Cause and Effect

This Wall Street Journal article highlights one of the sad facts of government regulation and intervention in the economy: one act of government intervention often creates the demand for additional intervention later on.

In 1936, the federal government anointed the ratings on bonds provided by the credit rating firms of the day (Moody's, Standard, Poor's, and Fitch) as the basis for determining whether assets held by banks were of high quality.

Once the idea took hold, the government expanded its use including Securities and Exchange Commission rules in the 1970's that made the ratings agencies a more important part of the financial marketplace.

While it sounds like a good idea, the problem was (and is) that it reduces the need for banks to make their own determination of the credit quality of an investment. It allows regulators to substitute the judgement of the rating agencies for their own when assessing credit risk.

Because investors and regulators relied so heavily on these ratings, banks took on more risk than they otherwise would have. While it isn't the fundamental cause of the financial crisis, it certainly contributed to it.

The government, having made the financial crisis worse with its original regulations, now is using the financial crisis to increase its regulations - no doubt sowing the seeds for future losses due to forseen and unforseend effects from new regulations.

With respect to the ratings agencies, the government needs to get out of the business of promoting their role on assessing investments. If there is a market demand for their services, then let that demand determine their role in deals. Perhaps it looks similar to what occurs today. Perhaps their business model changes.

And in all cases, investors will be forced to be more thoughtful in their investment decisions rather than letting the agencies be their "crutch".