Why did the rating agencies put their reputations at risk?

Is there anything less useful than AAA ratings of mortgage backed securities by S&P and Moody’s prior to 2006? The obvious answers, like “tits on a bull” or “an ashtray on a motor bike”, don’t deserve a passing grade. Tits on bulls do no harm and it is conceivable that an ashtray on a motor bike might actually be useful (see here).

I can understand some of the important elements that brought about the current financial crisis. With the benefit of hindsight it is now obvious that the U.S. Federal Reserve was allowing excessive credit expansion. A few economists – such as Roger Garrison and Steve Horwitz – are probably entitled to say “I told you so”, but most economists would have to admit that they didn’t think that low interest rates were a problem while consumer price inflation remained low.

I can also understand that government policies in the U.S. that were encouraging financial institutions to relax their lending standards would be likely to lead to an increase in defaults. That should have been obvious to anyone who didn’t come down in the last shower, but as far as I am aware few economists other than Stan Liebowitz and Theodore Day raised objections to the policies that were succeeding in lifting home ownership rates. As early as 1998, Day and Liebowitz warned that the method that government was using to increase home ownership among the poor – weakening underwriting standards so that mortgages required virtually no down payment – would lead to problems. They wrote: “After the warm and fuzzy glow of flexible underwriting standards has worn off, we may discover that they are nothing more than standards that led to bad loans”. The quote comes from an excellent article on causes of the mortgage meltdown that Stan Liebowitz has now written for the Independent Institute (“Anatomy of a train wreck”, October 2008, here).

However, I still can’t understand why the rating agencies would risk their reputations by giving AAA rating to innovative mortgage-backed securities. Liebowitz includes some discussion of the behaviour of rating agencies in his article. He suggests that their behaviour was “shortsighted to the point of incompetence”. The rating agencies were apparently strongly influenced by evidence that default rates on the more risky lending were no higher than on standard mortgages. The problem with that approach is that they derived their evidence solely from the period at the beginning of the housing price bubble. They apparently made no attempt to think about what might happen in the event of a such things as an economy-wide rise in interest rates, fall in house prices or increase in unemployment rates. Liebowitz also mentions that government regulation that requires many financial organizations (e.g. insurance companies and money market funds) to invest in securities that are highly rated by incumbent rating agencies may tend to shield these agencies from competition and make them reluctant “to create political waves by rocking the mortgage boat”.

Perhaps I should just accept that the rating agencies behaved incompetently. But there is something disturbing about the idea that firms that presumably can only exist so long as they maintain reputations for offering a trustworthy service would allow any of the common varieties of human fallibility – such as incompetence and greed – to put those reputations at risk. If a rating agency felt that it lacked the competence to rate a particular security I would have thought that it would be prudent for it to refrain from making a rating until it acquired the necessary competence. It is hard to imagine any organisation that would have a greater incentive to behave prudently than a rating agency. Government regulatory authorities are certainly not faced with such unambiguous incentives to maintain a reputation for prudence and competence.

It seems to me that, unlike the rating agencies, I should admit my incompetence. I do not yet understand why the rating agencies would put their reputations at risk.

Postscript:
Steve Horwitz has made the following comment that helps to answer my question:
"One reason the agencies rated the bonds so highly is that, thanks to some changes in SEC rules, the agencies switched their audience. For decades, they rated for an audience of investors. But in recent decades, they rated for the SELLERS of the instruments, who would then "agency shop" to get the best rating they could. This gave the agencies strong incentive to rate more highly than justified."