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Why companies do stupid things, credit rating edition—A Commentary by Simon Johnson and James Kwak ’11

The following commentary was published in The Washington Post on October 20, 2009.

Why companies do stupid things, credit rating edition
By Simon Johnson and James Kwak ’11

You often hear critics of government talk about how much better the private sector is at . . . well, just about everything. One common claim is that private corporations are better managed because of some combination of internal meritocracy, shareholder pressure and the profit imperative. This was the basis for Ross Perot's 19 percent of the popular vote in 1992 and the political careers of Michael Bloomberg and many others. However, this tenet of anti-government rhetoric suffers from a big problem: Many private corporations aren't very well managed, either.

Take the major credit rating agencies -- Moody's, Standard & Poor's and Fitch. These companies assign ratings to bonds issued by corporations and governments, ranging from AAA to D. (Specific scales vary slightly.) The ratings are supposed to reflect the expected likelihood that the bond will be paid back. During the boom, they gave AAA ratings to thousands of bonds issued as part of collateralized debt obligations backed by subprime debt (now known as "toxic assets"); over the past two years, over 60% of mortgage-backed securities have been downgraded, many to junk status, as it became clear that they were not, in fact, as safe as U.S. government debt.

This is all old news at this point. However, Kevin Hall of McClatchy has new news:

"Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

"Instead, Moody's promoted executives who headed its 'structured finance' division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk."

The story is documented by interviews with numerous Moody's insiders, many on the record.

Credit rating agencies have an internal tension in their business model. To bring in revenue, they have to satisfy their customers -- the investment banks creating structured finance products. However, for their product -- their ratings -- to have any value, they have to maintain certain standards for analysis and compliance.

This is actually a common tension in the business world. Many companies face conflicts between short-term revenue and long-term quality. As Alyssa Katz describes in "Our Lot," home builders cut corners on quality during the boom to meet their ever-increasing volume targets, leaving thousands of houses that are not only uninhabited today but also falling apart.

Similarly, a software company that sells large, complex products can gain more revenue by promising new features to customers -- but then the development team actually has to build those features. Many software companies, particularly during the Internet boom, collapsed in part because their salespeople and executives made promises that could not be met. Or, more insidiously, sometimes it is possible to deliver the promised feature on time, but only by compromising on underlying product quality, which comes back to bite you in future years.

Unfortunately, most companies have no effective way of balancing these imperatives. And the usual outcome is that the sales guys -- the ones who bring in the revenue -- win. It is common in American corporate culture for the "line" executives, the ones with profit and loss responsibility, to have contempt for the "staff" executives who don't. Risk management, compliance and accounting are all staff functions. The result, as at Moody's, is that companies cut corners to protect their short-term revenue streams, creating the potential for long-term disaster.

There are supposed to be two solutions to this problem in a capitalist system. One is shareholders, who are supposed to watch over the companies they own to make sure that managers are acting in their best interests. However, as "shareholder value" has become equated with short-term stock price -- no one says you have to hold on to your share of Moody's for the long term -- companies have become even more fixated on their stock prices. And this has only strengthened the hand of the sales guys who bring in the revenue needed to make earnings targets.

The other solution is the market; theoretically, customers should flow to companies that don't compromise on product quality, punishing those who do. But this doesn't necessarily work. Imagine there are two software companies: Company A maximizes short-term revenues at the expense of product quality, and Company B doesn't. The outcome should be that Company A's stock price will go up and it will use its inflated stock to buy Company B.

Instead, you are likely to end up with a race to the bottom as competitors all cut quality to maximize revenue. This is especially likely in oligopolies such as the credit rating agencies, where it is easy to settle into a long-term pattern in which no one is maintaining product quality.

On top of this, there is the problem that the credit rating agencies are a government-protected oligopoly. Moody's, S&P and Fitch are the three biggest "nationally recognized statistical rating organizations" (NRSROs), a designation granted by the Securities and Exchange Commission. Various federal and state regulations mandate the use of ratings granted by an NRSRO, further protecting them from competition. This is why Moody's still trades at $24 (down from over $70); no matter how egregious the mistakes it made during the boom, it isn't going away. So at the moment, we seem to face the unpleasant choice between a government-protected oligopoly that rewards failure and an unregulated market where participants would be left to their own devices, which would probably be even worse for investors.

Rating agency reform should be an important component of financial regulatory reform. But beyond that, the rating agencies serve as an example of why we can't depend on shareholders and markets to enforce socially beneficial behavior by companies. At the end of the day, we like to talk about free markets, but the companies that make up those markets rarely behave like rational actors. Perhaps this is the best we can do -- capitalism is perhaps still the worst economic system, except for all the others -- but we shouldn't leap from there to the conclusion that the business world is anything to admire.

Simon Johnson is a professor at MIT Sloan and senior fellow at the Peterson Institute. James Kwak is a Yale law student and former software entrepreneur. They blog about economics at The Baseline Scenario.