Region Focus, Spring 2009
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RF_FULL Covers_SPRING_09 8/12/09 5:10 PM Page 1 SPRING 2009 THE FEDERAL RESERVE BANK OF RICHMOND RF_FULL Covers_SPRING_09 8/12/09 5:10 PM Page 2 VOLUME 13 NUMBER 2 SPRING 2009 COVER STORY Our mission is to provide 14 authoritative information and analysis about the Reforming the Raters: Can regulatory reforms adequately Fifth Federal Reserve District realign the incentives of credit rating agencies? economy and the Federal Amid the financial turmoil, many have criticized the bond rating Reserve System. The Fifth agencies. How do these agencies operate? And what do economists District consists of the District of Columbia, have to say about the role they play in a healthy capital market? Maryland, North Carolina, South Carolina, Virginia, FEATURES and most of West Virginia. 20 The material appearing in Honeybees: Market for pollination services grows Region Focus is collected and Some beekeepers in the Fifth District sell pollination services to developed by the Research Department of the Federal farmers as far away as California’s almond fields. This market has Reserve Bank of Richmond. expanded as wild bee populations have declined and honeybee hives DIRECTOR OF RESEARCH have suffered from a variety of pests and problems. John A. Weinberg 23 EDITOR Aaron Steelman Silver Screen Subsidies: Is hoping to land the next Hollywood SENIOR EDITOR hit a sound economic development strategy? Stephen Slivinski State legislators often try to lure movie and television productions to MANAGING EDITOR their states. But the effectiveness of these policies as an economic Kathy Constant development tool is in question. STAFF WRITERS Renee Courtois 26 Betty Joyce Nash David van den Berg Clear Skies? The fight for dominance in the airline industry EDITORIAL ASSOCIATE The recession and oil price shocks have made for a turbulent few Julia Ralston Forneris years for the airline industry. Today, strong competition and shifts REGIONAL ANALYST in market realities are changing how airlines operate and will have Sonya Ravindranath Waddell CONTRIBUTORS real implications for future air travel. Matthew Conner 30 Christina Zajicek DESIGN Veto Politics: Can a line-item veto reduce spending? Beatley Gravitt Communications The line-item veto power held by a state governor is often thought to CIRCULATION keep the spending of the legislature in check. However, economists Alice Broaddus who have studied the issue have come to realize that the conventional Published quarterly by the Federal Reserve Bank wisdom may not be entirely correct. of Richmond P.O. Box 27622 Richmond, VA23261 www.richmondfed.org Subscriptions and additional DEPARTMENTS copies: Available free of charge through our Web site at 1 President’s Message/The (Limited) Role of Credit Ratings www.richmondfed.org/publications or by calling Research in the Financial Crisis Publications at (800) 322-0565. 2 Upfront/Economic News Across the Region Reprints: Text may be reprinted with the disclaimer in italics 6 Federal Reserve/Capital Cushions below. Permission from the editor is required before reprinting 10 Jargon Alert/Underemployment photos, charts, and tables. Credit 11 Research Spotlight/Have Free Markets Failed Us? Region Focus and send the editor a copy of the publication in which 12 Policy Update/Are CEOs Paid too Much? the reprinted material appears. The views expressed in Region Focus 13 Around the Fed/What Prolonged the Great Depression? are those of the contributors and not necessarily those of the Federal Reserve Bank 32 Interview/Allan Meltzer of Richmond or the Federal 37 Economic History/Sport of Kings Reserve System. 40 District Digest/Economic Trends Across the Region ISSN 1093-1767 48 Opinion/The Importance of Luck PRESIDENT’SMESSAGE The (Limited) Role of Credit Ratings in the Financial Crisis he cover story of this corporate bonds. This leads one to question the extent to issue of Region Focus which investors had a competing incentive to ignore coun- Tseeks to frame the tervailing information about the potential riskiness of the policy debate about the future securitized assets they were buying. of the credit rating agencies. It’s One plausible reason investors bought these securities certainly a timely discussion. involves the incentives built into the capital requirements When financial institutions that financial institutions must observe. Credit ratings began to post significant losses, issued by the agencies were used to assign “risk weights” to some observers suggested that the securities banks held. If the grade was high, banks could many financial institutions had hold less capital as a buffer against losses. That gave banks invested in new, complex secu- an incentive to hold the highest-yielding (that is, riskiest) rities — some of which have securities with any given rating — in short, potentially over- been downgraded to junk status rated securities. today — mainly because those assets were at that time Such a strategy might seem especially desirable to certain given a seal of approval by one of the “Big Three” rating financial institutions if market participants believed the agencies. Some of the reform proposals being discussed in federal government would treat those institutions as “too Washington are geared toward eliminating what many big to fail” and would take action to keep them alive in the argue were conflicts of interest that arose in the course of face of impending insolvency. This implicit promise to bail awarding those ratings. out institutions considered important to the stability of It’s important to acknowledge the concerns that many capital markets could have dampened market discipline no have about the agencies and how those agencies might have matter how good the information produced by rating agen- influenced the quality of investor information. After all, cies and others might have been. clear and reliable information is an important component of When the government is in the business of protecting a a properly functioning market. If an investor doesn’t under- certain class of investors and institutions against downside stand how a securitized asset is constructed — maybe risk, it should be no surprise that those investors and insti- because it is too opaque or simply too confusing to under- tutions are more likely to take on risk. It should also be no stand — market discipline may be weakened. Either a lack surprise that information which might have spurred caution of transparency or a lack of comprehension by the buyer of might be given less attention in such cases. an asset can lead to little or no check on the originators and Better information — whether through a reformed underwriters of those securities. rating process or through increased disclosure — could Yet it may not be entirely appropriate to blame the contribute to better functioning markets. But better infor- apparent shortcomings of the securitization markets simply mation alone will not be sufficient to bring effective market on the complexity of the products. If indeed that com- discipline to bear on institutions that are widely viewed as plexity raised sufficient concern among investors, it should too big to fail. What will be necessary is a widespread belief have been reflected in the prices of those assets. And if among investors that the government will not necessarily those risk premia were not as high as we think they should protect large institutions which make imprudent invest- have been after the fact, an undeserved credit rating may ments. So far, investors have little reason to believe that not have been the only contributing factor. It could be that is the case. Indeed, quite the opposite. Establishing tighter investors simply had an incorrect view of the future of the boundaries on the financial safety net — and making those economy or of particular institutions. boundaries well known and credible — is a key task facing Nor is it appropriate to place all the blame with the credit policymakers. rating agencies. Yes, an investor’s false sense of security may have been reinforced by the inflated grade given to a securitized asset by the rating agencies. But intelligent institutional investors also probably had some understand- ing that the ratings awarded by the Big Three agencies were flawed in certain respects. That could have just as easily been factored into the price too. And indeed it was, to JEFFREY M. LACKER some extent, as structured securities routinely traded at PRESIDENT spreads greater than similarly rated, but less complex, FEDERAL RESERVE BANK OF RICHMOND Spring 2009 • Region Focus 1 PFRONT U Economic News Across the Region Backyard Burn Coastal Wildfire Risk Swells with Population The worst wildfire in more than 30 years burned nearly 20,000 acres and sent smoke billowing over the Grand Strand near Myrtle Beach, S.C., in April after a backyard debris burn spread to an adjacent property. No one was injured, but the West. It makes more sense for the people the fire destroyed 75 whose assets are at risk to bear the cost of fire homes and damaged 101 suppression, so society doesn’t pick up the more. Four thousand whole tab. Jones says that his agency is work- people were evacuated. ing with insurance companies to consider South Carolina’s factoring the risk of fires into insurance rates. coastal development has To fight the South Carolina fire, the com- mushroomed since the mission got help from local fire departments biggest fire on record, as well as the United States National Guard. the Clear Pond Fire. In The Guard sent Black Hawk helicopters out- 1976, that fire burned fitted with 750-gallon buckets to scoop water 30,000 acres. The resi- from ponds to drop on the blaze. The Federal dential boom raises Emergency Management Agency will help questions about what’s South Carolina pay the Guard. Damage esti- become a problem, not mates from the fire fighting alone reached $1.5 just in South Carolina, million.