Robert Rosenkranz writes,

in effect, the regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating.

Indeed, that is the entire raison d’être of the $6 trillion structured-finance business, which serves little economic function other than as a rating-agency arbitrage. Subprime mortgages (and all manner of other risky loans) held directly by financial institutions are questionable assets with high associated capital charges. Each one alone would deserve a “junk” rating. Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade — thus turning dross into gold by a sort of ratings alchemy.

Read the whole thing. He recommends using interest rate spreads instead of credit ratings as a proxy for losses. The logic is that the market is likely to be better at assessing risk than the rating agencies.

I think his view has merit. Still, I believe that any attempt to regulate financial institutions using rules and formulas will be gamed. I think that letter-of-law regulation has to be supplemented by spirit-of-law rules. If the CEO’s of government-backed institution act in ways that are imprudent even though their actions are within boundaries of regulatory requirements, those CEO’s ought to face the risk of imprisonment.