Have We Learned Anything From 2007?

The financial analysts who rank public offerings for the ratings agencies, such as Standard & Poor’s and Moody’s, like to think they can be objective.

Their reliability is what they sell, really, along with expertise in puzzling out balance sheets. And no doubt they are acutely embarrassed by the role they played in the credit bubble that led up to the 2007 crash, when it turned out that they gave AAA ratings to many bonds based on worthless mortgages.

In retrospect, it has become clear that their mistakes were largely based on the fact that few analysts really understood the complex derivatives they were being paid to rate. Those new financial products ingeniously repackaged countless mortgages, slicing and dicing them, so that it became virtually impossible to grasp the risks.

But there was another factor that contributed to their failure: they were not fully motivated to puzzle it out. The very banks issuing the bonds paid their fees and wanted the best ratings for their products. The agencies, for their part, wanted the banks’ business. Moreover, the competitive frenzy that drove the market left little room for reflection and investigation. The virtually insatiable demand for the bonds, as money poured into America seeking safe returns, allowed so little time to study the risk that whatever reservations or qualms the analysts might have had about them were brushed aside.

Today, no doubt, with a better grasp of the financial complexity of these bonds, the analysts are in a better position to assess their risk. But do they grasp the psychological risk of their own complicity? Do they overvalue their ability to be objective?

The New York Times reported recently that the pressure of competition in the financial industry seems to be pushing the largest of the agencies, S. & P., to repeat the pattern: “industry participants say it has once again been moving to capture business by offering Wall Street underwriters higher ratings than other agencies will offer. And it has apparently worked. Banks have shown a new willingness to hire S. & P. to rate their bonds, tripling its market share in the first half of 2013. Its biggest rivals have been much less likely to give higher ratings.”

The return of the “ratings game,” as The Times called it, suggests that S. & P. doesn’t grasp the more insidious risk to its own credibility – not to mention to investors – of ignoring its vulnerability to unconscious collusion.

“In its response to the government lawsuit, the company said that its ratings had always been ‘uninfluenced by conflicts of interest.’” (See, “Banks Find S. & P. More Favorable in Bond Ratings.”) That is a particularly strong and unequivocal statement to make, especially in the light of its past failures.

No doubt, their statement was crafted by lawyers mindful of the on-going investigations into its behavior, up to and including 2007. But it is also likely that S. & P. proud of its new sophistication in analyzing risk, post 2007, is beginning once again to ignore the dangers posed by their own unconscious motivation. They place their faith entirely in numbers.

Psychologists know that it is impossible to be “uninfluenced by conflicts of interest,” especially when you keep denying it. Countless studies have shown how the mind unconsciously adjusts its perceptions to accommodate its interests and needs.

The best one can do is to acknowledge the conflicts and try to correct for them. In the long run, that will make the ratings agencies more credible, investors safer, and help protect the economy from new bubbles.