Did the credit agencies, such as S&P, overrate the bundles of mortgages?

BY Paul Solman  April 4, 2008 at 2:46 PM EDT

This installment’s “guest vetter” is Larry Koltikoff with Boston University. He is perhaps the best-known American economist on the issue of intergenerational conflict over entitlement spending on programs like Social Security and Medicare. You can check out his full bio here.

Question/Comment: Did the credit agencies, such as S&P, overrate the bundles of mortgages? Was it in their short term interest to do so?

Paul Solman: Yes, they overrated – literally. And yes, it would seem to have been in their short-term interest: it costs money to evaluate complicated securities. The less money they spend, the more they make. Plus, they take heat for underrating companies and securities, so they tend not to. Would you? The punch line for economists: as always, incentives matter.

Larry Kotlikoff, professor of economics at Boston University: Hindsight is 30/30 and it’s easy to condemn with only partial knowledge of the facts. Having said this, the rating agencies collectively rated 80 percent of subprime mortgage income flows as AAA, which seems extreme. Whether or not they were explicitly or implicitly bribed to do this, the reality is that this is as much as creditability crisis as a credit crisis. We need to move from actual or potential insider rating to a system in which the government does the rating itself, or securities and financial institutions. The government should also independently audit all 500 top U.S. corporations — a big job, I know. But these ratings and audits are essential to protect the financial markets from future confidence crises. They would not replace, but rather supplement private ratings and audits.