Rating the Raters
Steve Pearlstein had a nice column last Friday on rating agency reform -- which is arguably the most important aspect of financial regulation reform. They're the one player whose proper functioning could have prevented, well, everything. If all the trash had been rated as trash, that would have been the end of the game.
Instead, it was all rated as AAA gold. It's hard to say how many traders understood those ratings were nuts and how many were genuinely fooled. But it was a problem. And it was, in some ways, a predictable one: The ratings market is structured in a very peculiar way. Banks pay the rating companies to analyze their products. There are multiple companies, so they compete for the business of banks. And as you might expect, banks are interested in the company that will help them make the most money, not the one that will consistently downgrade their products. That means that if you want to be the rating agency that makes the most money, you'd better be the one that helps the banks make the most money. And the three major raters -- Standard & Poor's, Moody's and Fitch -- all competed to play that role.
It wasn't always this way. Pearlstein gives some history:
[P]eople who use a good or service should also be the ones who pay for it. That's how it works in most markets. And when it doesn't -- health care is a good example -- things tend to go awry.
It used to work that way in the credit-rating business as well, with investors paying directly for ratings and analysis through some sort of subscription arrangement, or indirectly through their brokers. But starting in the mid-1970s, after a number of high-profile bankruptcies, people decided it was important to make credit ratings publicly available to all investors. Companies that issued bonds began paying for the ratings themselves, and it didn't take long before agencies figured out that it was better for business if their ratings were a bit higher and their analysts were a bit slower to issue downgrades. By the time collateralized-debt obligations came along, it was not uncommon for agencies to provide issuers with behind-the-scenes advice on how to structure their new products to get the highest rates. The interests of the ratings agencies came to be perfectly aligned with those issuing the securities rather than those buying them.
The problem with ratings agencies is not that they're too big to fail. It's that they're too important to fail. The main solution you hear about is blind assignment. A public or nonprofit agency would simply direct a rater to each product. The rater's constituency would, in that scenario, be the agency, not the bank. That would at least rid the market of the perfect storm of misaligned incentives that plagued it until now.
I think you need to go further, however. So long as sellers are funding the ratings, it's hard to imagine raters being totally deaf to their needs. Buyers need to fund the ratings. But since there's no particular buyer anymore -- instead, the information is public -- then the public needs to be the purchaser, turning the rating agencies into something akin to public utilities.
The financial regulation conversation tends to focus on limiting leverage, and for good reason: That's the best way to keep a severe problem from contaminating the entire system. But radically reforming the rating agency market is probably the best way to keep the problem from getting so severe in the first place.
Photo credit: By Ethan Miller -- Getty Images
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