It is critically important to remember, as Krugman notes, the scandalous role of the ratings agencies in the subprime mortgage mess, which is all well-documented in Michael Lewis's marvelous book The Big Short.....It’s a strange situation.On one hand, there is a case to be made that the madness of the right has made America a fundamentally unsound nation. And yes, it is the madness of the right: if not for the extremism of anti-tax Republicans, we would have no trouble reaching an agreement that would ensure long-run solvency.On the other hand, it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really?Just to make it perfect, it turns out that S&P got the math wrong by $2 trillion, and after much discussion conceded the point — then went ahead with the downgrade.More than that, everything I’ve heard about S&P’s demands suggests that it’s talking nonsense about the US fiscal situation....In short, S&P is just making stuff up — and after the mortgage debacle, they really don’t have that right.
I passed my copy on and don't have it to quote from but read this excerpt from an interview with Michael Lewis by Terence McNally (the TM in the excerpt below):
ML: The sub-prime mortgage bonds were rated triple A by Moody's and Standard and Poor's. Why? Well, they could give you an argument, but in retrospect, it looks like a very foolish argument.
TM: It looks worse than foolish to me, it looks corrupt.
ML: When you think about corruption, there's the simple kind where I give you $1000 to interview me on the radio so it will promote my book. That's corrupt and we both know it. But there's a different sort of corruption where we're all part of a system that is rewarding us very well to pay attention to certain things and not pay attention to others. We're paid to have blind spots. There's an awful lot of that kind of corruption in the financial system because people's incentives are all screwed up.
Ratings agencies were paid by the people who issued the bonds to put the triple A rating on them. Their incentive is to please the people who are issuing the securities. They can't at the same time independently judge the securities.
TM: Arthur Andersen went out of business for doing basically the same thing with Enron. How could someone not see that they were recreating something which had already failed in a huge way?
ML: Some people did see...The people I find most riveting are the people who saw the magnitude of the coming disaster. They were sane men in an insane world. They would call Standard and Poor's and Moody's and say, "How are you rating these things? Our models show that if house prices even go flat, all these bonds will be worthless." To the question of what happens to these bonds if house prices go down, Standard and Poor's would say, "We actually don't know because there's no place in our model to put a negative number."
TM: Obama, Geithner and the administration are putting out plans for new regulations. This isn't in there?
ML: No. It should be illegal for issuers to pay raters for ratings. It's a bribe. Instead the administration says they're going to give the regulators more authority to evaluate ratings agencies. That doesn't do anything; they already had that authority.