3 Bond-Rating Corporations, Protected from Competition by SEC Regulations, Gave Triple-A Ratings on Mortgage-Backed Securities

The role of incentives is explicitly considered in Friedman and Kraus (2011); these authors embrace the regulatory failure thesis. In particular they debunk various elements of the conventional wisdom about what caused the financial crisis and argue that the crisis was a regulatory failure in which the prime culprit was the set of regulations governing banks’ capital levels known as the Basel rules. Theirs is an “incentives story” but it is not a moral-hazard story. They stress the role of radical ignorance on all sides. The triple-A ratings on MBS were conferred by three bond-rating corporations that had been protected from competition by Securities and Exchange Commission regulation dating back to 1975. Not only bankers but investors of all kinds were either unaware that these three corporations were protected, or they were unaware of the implications of this protection for the accuracy of their ratings. This lack of awareness was apparently shared by the banking regulators, who had incorporated the three companies’ ratings into the Recourse Rule and Basel II. The financial crisis was transmitted into the nonfinancial or “real” economy through a lending contraction that began in mid-2007, as banks were required to “mark to market” their holdings of mortgage-backed securities in line with market fears about the value of these securities, due to rising rates of subprime mortgage delinquencies.

—Ludwig Van Den Hauwe, “Understanding Financial Instability: Minsky Versus the Austrians,” in “Revisiting the Hayek-Keynes Debate in Light of the 2008-2010 Crisis,” special issue, Journal des Économistes et des Études Humaines 22, no. 1 (2016): 51.