Mark A. Calabria’s research while affiliated with Cato Institute and other places

During the financial crisis of 2008, the financial markets would have been better served if the credit rating agency industry had been more competitive. We present evidence that suggests the Securities and Exchange Commission’s designation of Nationally Recognized Statistical Rating Organizations (NRSROs) inadvertently created a de facto oligopoly, which primarily propped up three firms: Moody’s, S&P, and Fitch. We also explain the rationale behind the NRSRO designation given to credit rating agencies (CRAs) and demonstrate that it was not intended to be an oligopolistic mechanism or to reduce investor due diligence, but rather was intended to protect consumers. Although CRAs were indirectly constrained by their reputation among investors, the lack of competition allowed for greater market complacency. Government regulatory use of credit ratings inflated the market demand for NRSRO ratings, despite the decreasing informational value of credit ratings. It is unlikely that this sort of regulatory framework could result in anything except misaligned incentives among economic actors and distorted market information that provides inaccurate signals to investors and other financial actors. Given the importance of our capital infrastructure and the power of credit rating agencies in our financial markets, and despite the good intentions of the uses of the NRSRO designation, it is not worth the cost and should be abolished. Regulators should work to eliminate regulatory reliance on credit ratings for financial safety and soundness. These regulatory reforms will, in turn, reduce CRA oligopolistic power and the artificial demand for their ratings.

While Fannie Mae, Freddie Mac, and private subprime lenders have deservedly garnered the bulk of attention and blame for the mortgage crisis, other federal programs also distort our mortgage market and put taxpayers at risk of having to finance massive financial bailouts.The most prominent of these risky agencies is the Federal Housing Administration (FHA). The FHA currently backs an activity portfolio of over $1 trillion. With an economic value of only$2.6 billion, representing a capital ratio of 0.24 percent, relatively small changes in the performance of the FHA's portfolio could result in significant losses to the taxpayer. As the taxpayer is, by law, obligated for any losses above the FHA's current capital reserves, these are not losses that can be avoided. Reasonably foreseeable changes to the FHA's performance could easily cost the taxpayer tens of billions of dollars, surpassing the ultimate cost of the Troubled Asset Relief Program (TARP) bank bailouts.To protect the taxpayer and the broader economy, the FHA should be scaled back immediately, and an emphasis should be placed on improving its credit quality. At the same time, the agency should be placed on a path to ultimately be eliminated, with its risk-taking being transferred back to the private sector.

The recent financial crisis was characterized by losses in nearly every type of investment vehicle. Yet no product has attracted as much attention as the subprime mortgage.What is generally agreed is that subprime mortgages disproportionately contributed both to the severity of the crisis and to the size of losses imposed upon the taxpayer. What remains in dispute is the role of government — specifically, that of Fannie Mae and Freddie Mac — in expanding the availability of subprime mortgage credit.Changes in the mortgage market, resulting largely from misguided monetary policy, drove a frenzy of refinancing activity in 2003. When that origination boom died out, mortgage industry participants looked elsewhere for profits. Fannie and Freddie, among others, found those illusionary profits in lowering credit quality.Foremost among the government-sponsored enterprises' deleterious activities was their vast direct purchases of loans that can only be characterized as subprime. Under reasonable definitions of subprime, almost 30 percent of Fannie and Freddie direct purchases could be considered subprime.The government-sponsored enterprises were also the largest single investor in subprime privatelabel mortgage-backed securities. During the height of the housing bubble, almost 40 percent of newly issued private-label subprime securities were purchased by Fannie Mae and Freddie Mac.In order to protect both the taxpayer and our broader economy, Fannie Mae and Freddie Mac should be abolished, along with other policies that transfer the risk of mortgage default from the lender to the taxpayer.