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A clearinghouse for ratings agencies

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It seems like the rating-agency problem should be simple: Right now, the banks pay them to rate their securities. That creates a conflict of interest. Solve that conflict of interest and you've solved the problem.

Sadly, Kevin Drum has done a good job convincing me that ratings-agency reform is insanely complicated and most solutions will bring new problems. That said, you don't want your inability to find a perfect solution prevent you from settling on a better equilibrium. And David Raboy's idea to create a clearinghouse "to receive rating applications from securities issuers and then farm out assignments in a random or unpredictable way" might be that better equilibrium:

The funding, which could come from a financial-transaction fee, would need to cover the operations of the clearinghouse as well as the ratings process itself. The performance of the rating agencies would periodically be compared on the basis of simple, transparent criteria, such as the number of times that investment-grade bonds defaulted or lost significant value. The most accurate rating agencies could be rewarded with additional assignments. Those with the poorest records could, in extreme cases, be suspended or removed from the pool.

More here.

By Ezra Klein  |  April 30, 2010; 12:07 PM ET
 
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Comments

Terrible idea -- enshrines further a flawed system.

Rating agencies rarely are ahead of the market in assessing credit quality -- the much-derided credit default swap market is far more accurate. Why institutionalize this oligopoly?

Two simple ideas: (1) Remove ratings as a criteria in SEC and other regulations -- in addition to providing only the illusion of protection (see, e.g., AAA-rated CDO tranches), the current system requires the SEC to designate qualified rating agencies, which gives them an imprimatur from the federal government.

(2) If a rating agency is paid by the issuer of the security (or another interested party, like the dealer), it loses its protection from liability.

It's not really that complicated.

Posted by: Craig643 | April 30, 2010 1:28 PM | Report abuse

Along the lines of what Craig mentioned, check out this piece in yesterday's FT:

http://www.ft.com/cms/s/0/28df0210-52f8-11df-813e-00144feab49a.html

"....What should be done about it? A place to start would be to remove their “regulatory licences” – the status of Nationally Recognised Statistical Rating Organisation – or at least to open the status up more broadly. That might worry regulators who like some official seal of approval, but it would also reduce the halo effect.

Frank Partnoy, a law professor at San Diego University, argues that there is an alternative market mechanism for judging risky investments in credit default swap spreads (which have proved better predictors of forthcoming defaults than ratings). Instead of being told to invest in only triple-A securities, investors could buy bonds with low swap spreads. He also argues in favour of removing the protection that ratings agencies enjoy under US securities law from investor lawsuits relating to securities they rate before they are underwritten. At the moment, they are far more protected than banks or accountants.

Last, politicians and regulators must take a long, hard look at the conflict of interest in agencies being paid by issuers, and so having an incentive to boost ratings. The subcommittee heard stories of analysts being placed under strong pressure to “maintain market share”.

None of these reforms would be easy to implement. Some have been mooted in previous crises without any big changes to the status quo. But this crisis was of a severity beyond others in the past, and triple-A securities were at its heart. It is time to curb the power and influence of the agencies behind them."

Posted by: Castorp1 | April 30, 2010 1:41 PM | Report abuse

The solution is actually really easy. Just make it so that if a rating is requested, it has to be disclosed publicly. That way if a company shops around for a better rating, there will be transparency as to how the rating agencies differ. Companies may want to gravitate to the loosest agency, but investors would know this and be able to take that into consideration accordingly into their own risk assessments.

Posted by: JohnnieVoodoo | April 30, 2010 3:41 PM | Report abuse

I am an avid reader of this blog and Kevin's and I am pretty surprised that both of you have now propped up this same silly strawman assuming that, for some reason, because the private ratings agencies currently rate foreign sovereign debt, so to must the SEC if it is to assume some new responsibilities in rating securities, bonds and derivatives issued in the US. In reality, there is no reason why a rating agency MUST rate foreign sovereign debt IN ADDITION to rating securities, bonds, etc. None at all. Of course, foreign sovereign debt COULD have some indirect impact on the value of such domestic issuances, but that does not mean the SEC will be rating foreign sovereign debt. FICO scores would also have some indirect impact on domestic issuances (thinking mortgage backed securities here), but nobody is saying that the SEC would be required to rate the credit of US consumers merely because they are rating securities. This is a straw man.

If anything, however, it does help illuminate an important point: the SEC does not need to rate everything the world around. It is sufficient to merely rate the bonds, securities and derivatives being issued in the US. In practical terms, this is all the SEC really could rate easily given natural limitations on its jurisdiction to enforce US laws extra-territorially.

I recently read one of Chait's posts in which he said financial reform was not as ripe as health care reform since the progressive base hadn't spent years thinking about the problem. That is probably true, but there are plenty of honest people who are smart enough to make good laws now and bloggers really need to ask more questions before burying their heads in the sand and saying it is all just too complicated to work out right now. Good legislation is probably more about timing than policy. And we may not have this opportunity again for awhile.

Posted by: Zac555 | May 2, 2010 11:26 PM | Report abuse

I am an avid reader of this blog and Kevin's and I am pretty surprised that both of you have now propped up this same silly strawman assuming that, for some reason, because the private ratings agencies currently rate foreign sovereign debt, so to must the SEC if it is to assume some new responsibilities in rating securities, bonds and derivatives issued in the US. In reality, there is no reason why a rating agency MUST rate foreign sovereign debt IN ADDITION to rating securities, bonds, etc. None at all. Of course, foreign sovereign debt COULD have some indirect impact on the value of such domestic issuances, but that does not mean the SEC will be rating foreign sovereign debt. FICO scores would also have some indirect impact on domestic issuances (thinking mortgage backed securities here), but nobody is saying that the SEC would be required to rate the credit of US consumers merely because they are rating securities. This is a straw man.

If anything, however, it does help illuminate an important point: the SEC does not need to rate everything the world around. It is sufficient to merely rate the bonds, securities and derivatives being issued in the US. In practical terms, this is all the SEC really could rate easily given natural limitations on its jurisdiction to enforce US laws extra-territorially.

I recently read one of Chait's posts in which he said financial reform was not as ripe as health care reform since the progressive base hadn't spent years thinking about the problem. That is probably true, but there are plenty of honest people who are smart enough to make good laws now and bloggers really need to ask more questions before burying their heads in the sand and saying it is all just too complicated to work out right now. Good legislation is probably more about timing than policy. And we may not have this opportunity again for awhile.

Posted by: Zac555 | May 2, 2010 11:27 PM | Report abuse

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