Sometimes the refs really do suck

In 2004, professional basketball fans were treated to the “Malice at the Palace,” the name given to the famous Detroit Pistons-Indiana Pacers brawl that took place at Auburn Hills. Years of distrust and enmity between two rival teams finally boiled over at the end of an extremely physical game. Fists flew, benches cleared and players went into the stands to battle the fans. The police were called in and the remainder of the game was cancelled. In the aftermath, players were suspended, people went to jail and the NBA dramatically increased its oversight of players’ on and off court behavior.

The somewhat ironic location of the brawl highlights a metaphorical connection to today’s credit crisis. The NBA’s (read: government) failure to provide adequate oversight of both the players (companies) and the game (financial markets) led to a brawl (credit crunch) that ended up injuring fans (economic recession). In the post-melee analysis it became clear that players, fans and the NBA all shared some portion of the blame. One group that went notably absent from criticism was the referees who let that game get out of hand.

One could argue that the credit ratings agencies (Moody’s, S&P, Fitch) act as referees in the financial marketplace. They don’t set the rules of the game and they don’t decide who gets to play in the game, but using their credit ratings as a whistle, they interpret what constitutes a foul, and which shots should be rewarded with points. They can dramatically impact the outcome of game and players, coaches and fans do everything they can to manipulate their calls.

One could also argue that the rapid escalation of the crisis resulted from bad refereeing by the credit agencies. For years they failed to adequately scrutinize the underlying risk of mortgage backed securities, only taking notice after the risk had burrowed its way into the foundations of our economy. Once that risk became apparent, how did they respond? By threatening or issuing waves of ratings downgrades that ground the credit market to a halt and sent companies into a frantic scramble for capital.

Their actions are not unlike those of ineffective referees who, having kept their whistles in their pockets for the first three quarters of play have allowed the game to get way out of hand. Suddenly they realize something is wrong, and in a vain attempt to restore order they blow their whistles and start handing out fouls to everyone. Things that were acceptable in the first quarter now suddenly merit a technical foul. The fans erupt, players behave irrationally and eventually the game grinds to a halt.

In retrospect, we really should have seen this coming. The agency problems extant in the industry are well-known. Ratings agencies are paid for their services by the very companies whose creditworthiness they are supposed to analyze. This is hardly a recipe for objectivity. While criticism has already begun to emerge from some corners, we haven’t seen any real outrage at the role of credit-rating agencies. Before lobbing “sleeping at the wheel” accusations at the SEC, the Fed, banks and irresponsible homeowners, we should consider taking a hard look at the credit ratings agencies that stood by and blithely let the game go on.