"In fact, they are in the nature of swindles. "

Skidelsky on the New Straits Times:

"ECONOMICS, it seems, has very little to tell us about the current economic crisis( TRUE ). Indeed, no less a figure than former United States Federal Reserve chairman Alan Greenspan recently confessed that his entire "intellectual edifice" had been "demolished" by recent events. Scratch around the rubble, however, and one can come up with useful fragments. One of them is called "asymmetric information".

This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice-versa. Interesting things happen -- so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price.

Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behaviour, physical health and so on.

The insurer faces "adverse selection", because he cannot distinguish between good and bad risks. He, therefore, sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks -- the quick road to bankruptcy.

There are various ways to equalise the information available -- for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the "efficient market hypothesis" -- the dominant paradigm in finance -- assumes that everyone has perfect information and, therefore, that all prices express the real value of goods for sale( IT'S A MODEL ).

But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical "adverse selection" problem arises when banks can't tell the difference between a good and bad investment -- a situation analogous to the insurance market.

The borrower knows the risk is high, but tells the lender it is low( THIS IS FRAUD ). The lender who can't judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e. asymmetric information lets toxic loans onto the credit market.

Other models use principal/agent behaviour to explain "momentum" (herd behaviour) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment's thought will show why these models cannot explain today's general crisis. They rely on someone getting the better of someone else: the better informed gain, at least in the short-term, at the expense of the worse informed. In fact, they are in the nature of swindles( THAT'S EXACTLY WHAT THEY ARE ). So these models cannot explain a situation in which everyone, or almost everyone, is losing -- or, for that matter, winning -- at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together.

They differ only in believing that not everyone possesses it. In Akerlof's example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows well how likely it is to break down, and the buyer does not( FRAUD ).

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse( FRAUD ); but they are deceiving themselves that they know more than they do.

If only one person were perfectly informed, there could never be a crisis -- someone would always make the right calls at the right time.

But only God is perfectly informed, and He does not play the stock market.

"The outstanding fact," John Maynard Keynes wrote in his General Theory of Employment, Interest and Money, "is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." ( TRUE )

There is no perfect knowledge "out there" about the correct value of assets, because there is no way we can tell what the future will be like( TRUE )

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety( THAT'S THE MAIN POINT. SAFETY ) in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today. "

I'm wondering why he assumes that there are no laws concerning business transactions?

"A lot has been said and written about the role of credit agencies in the current crisis."

Another post via Emre Deliveli's Blog On Economics. From the World Bank:

"Reforming the Credit Rating Agency Industry

A lot has been said and written about the role of credit agencies in the current crisis. Almost everyone agrees that its role has been negative( CRIMINAL. FRAUD. COLLUSION ), understating( FALSIFYING ) the risk of many financial products and papers and misleading ( FIDUCIARY MISMANAGEMENT )many investors. But how can the incentive structure of this industry be reformed( A DIFFERENT PAYMENT SYSTEM )? Is tougher regulation the response( TOUGHER SUPERVISION )? Or perhaps more competition in a three company industry( A CARTEL. COLLUSION. THE BIG THREE SHOULD BE AT LEAST SHUNNED )?

A recent theoretical paper by Patrick Bolton, Xavier Freixas and Joel Shapiro (The Credit Ratings Game) offers some suggestions towards reform of the industry, but also clearly shows that there are no silver bullets. As any theoretical model, it relies on simplifying assumptions( IT ALWAYS DOES ), but it presents very clearly the incentives faced by different stakeholders, including credit rating agencies and issuers of securities, and how different policy measures will affect them. At the core of the incentive problem is the fact that it is the issuers who buy ratings rather than the "users", i.e. investors, and that issuers can shop around for good ratings( CONFLICT OF INTEREST ).

Their model is relatively simple, but the results depend critically on the existence of naïve investors who believe the credit rating agencies’ stated ratings alongside sophisticated investors who form their own opinion. The issuers of commercial paper will never buy a bad rating, so credit agencies have an incentive to overstate the quality of any given issuance if the reputation costs (i.e. future lost profits) are low enough or the share of naïve investors large enough( OK ). An increase in the number of credit agencies, i.e. more competition, makes investors actually worse off as it gives issuers more opportunity to shop around for a good rating( TRUE. BUT THE METHOD OF PAYMENT IS KEY ).

The Cuomo plan (named after NY Attorney General Andrew Cuomo) to require up-front fees before the rating is published provides credit agencies with better incentives( NOT REALLY ) to rate truthfully, but does not prevent issuers from shopping around for good ratings. An improvement upon this plan would be to prohibit shopping( A TERRIBLE IDEA ), so that issuers are tied to one credit rating agency (similar to enterprises having to choose one auditor for their financial statements). An alternative reform suggestion is to go back to investor-paid ratings – as done in the U.S. until the early 1970s – and use a transaction tax to overcome the free-rider problem.( THAT'S BETTER )

All three suggestions, however, raise moral hazard concerns, as credit rating agencies have reduced incentives to properly assess and rate new papers. This is a risk that in turn calls for proper regulation and supervision( I LIKE THIS BETTER ) of the credit rating agencies industry, including significantly increasing reputational costs( I'M FINE WITH THAT. YES. ).

Some good ideas. I like:

1) Investor Paid Ratings

2) Supervision

3) Increasing Reputational Costs

Finally, I would limit their ratings to clearly defined investments, leaving CDSs and CDOs to be done by investors. If 1 is implemented, I could accept that.