credit ratings and regulation

The ratings agencies were comically^* inept at rating credit tranches of, well, everything five years ago, and are probably not much better now.  Even when rating boring old corporate and sovereign bonds, they've typically been at best a lagging indicator of events; wherever there's a quasi-liquid market indication of whatever it is the credit ratings are supposed to mean, the market has typically priced in an increase in credit risk long before the ratings get around to doing downgrades.  It may be that they provide some value in the case of new issues; their ratings of bonds from companies that haven't previously issued bonds before may impound some research that would be costly for a lot of bond investors to replicate.  It seems mostly, however, as though 1) the credit ratings are inadequate, 2) the market knows it, and 3) the only reason the credit ratings carry any importance at this point is because of capital regulations — various banks and insurance companies are required to hold a certain amount of their assets in securities with various ratings, or else are required to maintain leverage ratios that depend on the securities' credit ratings.

Many large investment banks spent much of the middle of the last decade specifically constructing securities that they knew would get high credit ratings, but with as high a yield as possible, so that regulated entities would want to buy them. The very fact that they had high yields should have been a tip-off to regulators; the market is not always efficient, but there are certain ways in which it tends not to be too inefficient, and if a liquid marketable security, in times of low credit spreads and rising stock markets, has a high yield, it might be worth the regulators' wondering whether the market collectively knows something that a simplistic model has missed.

If we really think a fund of some sort should only, by regulation, invest in securities with some maximal leverage, perhaps it would make sense to impose (say) a 75% tax on gains above some maximum rate of return; perhaps 2 percentage points above ten or thirty year treasuries would be "investment grade".  This idea isn't quite just motivated by a general belief in a risk/reward tradeoff, though it's perhaps more closely related than should be made distinct: the idea is to get these investors in the mindset that, conditional on such-and-such a return, we're optimizing risk, rather than vice-versa.  This shifts the competition for pension-fund dollars from price-competition to quality-competition, in essentially the classical way in which this is done; by making it impossible for a creator of securities to compete by offering higher yields, I'm hoping they will be compelled to compete by offering more safety — safety as determined by what the market knows now, and not just information that is old enough to have finally been acknowledged by the ratings agencies.

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^* I have a sick sense of humor.