My movie viewing for this week was The Big Short, it wasn’t quite what I thought going into the movie (it was billed as some sort of financial heist movie), but I thought it was very well done. For anyone who is interested, it came off as a witty documentary about the financial collapse that caused the Great Recession with A-list actors portraying the key players that the film follows through the collapse. It does a fairly good job of explaining how the collapse came about in a non-technical way, and without losing audience attention in the process. I recommend the film to anyone who is curious to learn more about the causes of the recession, or even just looking to see an entertaining film and learn something in the process.

As an economist who was learning his trade during the later years of the recession and the period following it, I am somewhat familiar with the causes of the collapse and therefore didn’t learn anything too new myself, although the film did offer some insights on the events as they unfolded by way of viewing them through the eyes of the key characters of the film who were investigating the legitimacy of the real estate market in order to ascertain whether there was in fact a bubble in the market. The biggest take away for me was an issue regarding the credit rating agencies, whose complete failure to accurately report the riskiness of mortgage backed securities as well as derivatives of those securities was a big factor in the crisis. I had been familiar with this failure in reporting being a key factor that allowed the crisis to form the way it had prior to viewing the film, but the film presents an alternate explanation as to why this failure may have come to pass than what I had previously heard.

Before, the reason for this failure had been presented to me as largely due to a lack of understanding of how these securities worked due to their being a relatively new type of tradable asset. There wasn’t the historical data for analysts to come to a solid conclusion as to how risky they were, and with a lack of evidence one way or another, they were just assumed to be solid investments. Essentially incompetence on behalf of the rating agencies was the argument, however the film makes an argument that this was not the only reason behind the agencies failure. I should state here that the film is also somewhat dramatized, so I can’t attest as to whether or not the scene that leads to this conclusion actually happened in real life, but either way it raises a legitimate concern. This concern being that rating agencies deliberately neglected to properly report risk of assets in order to keep from losing business to competing agencies who might report higher confidence in assets, and therefore be the rater of choice for anyone looking to sell the assets in question. This is a consideration because agencies collect fees for rating an asset from the institution selling the asset and therefore the more assets you rate, the higher your profit margin.

This particular insight stuck with me after seeing the film partly because it implies a more corrupt and dishonest view of events than I had reason to take before (which is undoubtedly intentional on the filmmakers part as it fits their thesis), but also, and more importantly, because it has policy applications.  Obviously a system wherein credit rating agencies generate revenue from those that they rate rather than the end users of the information they provide has the potential to create incentives to bias the accuracy of their ratings at the expense of those who depend on them. The theory that this is in fact what happened would certainly explain why more care was not taken in order to verify that assuming that these assets were solid was never taken.

Were I in position to advise on policy regarding industry practice I would strongly recommend that rating agencies be moved from a revenue model that relies on rating fees imposed on asset sellers to one that depends on charging rating users. What this new model would look like, I don’t know. Usage of rating info is a  hard thing to monetize due to ease of information sharing, which is why this model was moved away from in the 1970s. An effective system of law would have to be put into place for penalizing unauthorized users of rating information, essentially ratings obtaining unauthorized credit ratings would have to be treated in a similar manner to a company stealing trade secrets from a competitor. Or alternatively have ratings treated as insider trading if wrongfully applied. The problem would be in proving that one had access to unauthorized information and not simply following market trends set by the trading patterns established by those who do pay for rating info. This could be a very difficult and costly thing to prove.

Exactly how to reform the credit rating industry is less than clear, and would likely not be an easy undertaking, but until something is done to better align rating agency incentives with buyers of debt instead of debt issuers, we are putting ourselves at needlessly high risk from bubbles and the increasingly fatal consequences of their busts in the ever more interconnected, “too big to fail” economy that we live in.