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Should we nationalize the ratings agencies?

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Kevin Drum says that the issue with the ratings agencies is more complicated than people realize. Obviously it's a problem that the ratings agencies are paid by the banks whose products they're rating. But, Drum says, the common solution -- to have a regulator assign the ratings agencies rather than letting the bank do it -- will create problems of its own.

If you do this, the ratings agencies no longer have any incentives to do much of anything. There are three of them, and presumably each one would get a third of the business at a price set by the SEC. So their incentive would be to hire the cheapest possible analysts and cut costs to the bone. The result would be ratings agencies even less able to cope with complex modern securities than the current ones.

This is what stonkers me about the ratings dilemma: there just doesn't seem to be any good answer. Turning the ratings agencies into regulated utilities might be better than the current situation, but not by much. And if you're going to do that, why bother with ratings agencies at all? Why not just have the SEC provide ratings?

Actually, why not? This is a question I've asked for a long time and never gotten a really good answer to. The ratings agency business has two apparent settings: Hopeless conflict of interest or heavily regulated utility with an incentive to cut costs. But they play a very important role in the system. So why not make them -- or some basic version of them -- public? It would be better for both accountability and incentives.

The obvious problem is that a public rating agency might be too conservative, but on the one hand, I'm not sure that's a bad thing, and on the other hand, the market could always ignore the rating. It's much more dangerous for the ratings agencies to be paid to tell the market what it wants to hear rather than for them to be erring on the side of conservatism and forcing the market to think hard about whether the thing it wants to hear is really true.

Photo credit: Fred Prouser/Reuters.

By Ezra Klein  |  April 27, 2010; 1:54 PM ET
Categories:  Financial Regulation  
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Comments

Back in the days of yore, the rating was something paid for by the prospective buyer. I don't know how you force things back into a situation like that.

The House bill at one point or another basically eliminated the importance of ratings in all regulation. So that it would in effect require everyone to go back to doing due diligence. But I forget exactly how it worked. It seemed like a good idea, and something Republicans supported.

Posted by: NicholasBeaudrot | April 27, 2010 2:10 PM | Report abuse

The problem is that some investors cannot simply ignore ratings. They are constrained to invest in only those securities that are at or above a certain level.

Posted by: ThomasEllis | April 27, 2010 2:15 PM | Report abuse

The ratings agencies already have the "cheapest possible analysts." These guys are the very lowest rung on the Wall Street totem pole, are considered losers and idiots by the people whose products they are supposed to rate.

Posted by: randrewm | April 27, 2010 2:15 PM | Report abuse

There are a whole lot of institutions that are restricted to buying, for example, AAA or AA bonds. That puts a premium on rating everything up. That also fueled the ratings abuse.

It would seem that a conservative public entitly would be the best way to go. Giving an imprimatur to other people's deals is too open to abuses, both withholding material information and threatening to takle business elsewhere. Anyone who wanted to buy "x-rated" or unrated bonds would be free to do so if it was consistent with their charter, and investors should read prospectuses more carefully. It really is true that one should not invest in anything one can'tr understand, and things that sound too good to be true usually aren't.

Posted by: Mimikatz | April 27, 2010 2:19 PM | Report abuse

This notion that you don't like the ratings that you're getting so you'll just change the rules to control the outcome borders on criminal.

Why not just clean up your act instead of trying to remake the rules under which you are judged?

Which would be more honest?

Posted by: WrongfulDeath | April 27, 2010 2:27 PM | Report abuse

USDA inspectors test grains and cotton, both of which have derivatives, called commodity futures, tied to them. So why not public raters?

Posted by: bharshaw | April 27, 2010 2:28 PM | Report abuse

Why wouldn't the buy side pay for the rating instead of the sell side? So, in the case-du-jour, Goldman isn't allowed to pay Moodys, Paulson and ACA or IKB each individually pay for a rating. At least for the over the counter stuff. Sorry, perhaps an ignorant question.

Posted by: BHeffernan1 | April 27, 2010 2:35 PM | Report abuse

Utilities have to apply for licenses, submit pricing for approval, and maintain strong safety records.

Maybe we should just put the licenses for rating agencies up for renewal more often, regulate how much they charge, and put their ratings' accuracy to some level of accountability.

Posted by: rglvr | April 27, 2010 2:38 PM | Report abuse

How about making the rating agencies legally liable for cases where their rating turns out to not reflect the real value of the asset in question? It does not ensure that their ratings will never be wrong, but it sure does change the underlying incentives. This is similar to rules in some but not all states where a home inspector is liable for any later repairs if they miss a defect in the house after they have issued a clean bill of health. Again it doesn't ensure that mistakes won't be made but they are now more likely to be innocent mistakes rather than due to active malfeasance.

Posted by: mufti2 | April 27, 2010 2:43 PM | Report abuse

And if the SEC does it, how do you avoid regulatory capture?

Posted by: BobN1 | April 27, 2010 2:48 PM | Report abuse

Mimikatz- the alternate method to deal with the artificial increased demand for highly rated assets would be to weaken the requirements for some types of institutions. I mean heck look at some of these insurance companies- MetLife has a nearly $40B, Berkshire Hathaway speaks for itself, they should not necessarily be restricted to a class of assets with overinflated value that may not actually reflect low risk.

Posted by: tmorgan2 | April 27, 2010 2:50 PM | Report abuse

"Why not just have the SEC provide ratings?***
Actually, why not?"

The SEC? The agency that can't shoot straight? That SEC?

"It's much more dangerous for the ratings agencies to be paid to tell the market what it wants to hear rather than for them to be erring on the side of conservatism and forcing the market to think hard about whether the thing it wants to hear is really true."

That's certainly an interesting perspective: the govt might do such a horrible job that buyers would be forced to work harder to perform their own ratings, and that would be a good thing. Your theory of optimal govt and mine differ.

Posted by: ostap666 | April 27, 2010 3:02 PM | Report abuse

How could you monopolize a rating agency? How do you prevent a private company from issuing ratings on securities? At best, it seems the SEC could offer its own set of ratings in addition to the existing 3 rating agencies .

Posted by: mikehoffman82 | April 27, 2010 3:04 PM | Report abuse

Ezra,

We have defacto nationalization of them. Moody's, S&P, Fitch and the Canadian agency (due to NAFTA) are NRSO's, Nationally Recognized Statistical Rating Organizations. You get this status via a letter of Non Enforcement from the SEC.

This Wiki entry explains it nicely:
http://en.wikipedia.org/wiki/Nationally_Recognized_Statistical_Rating_Organization

And so does: "The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness" by Timothy Sinclair

Here is a key paragraph from the Wiki:

>>>>The use of the term NRSRO began in 1975 when the SEC promulgated rules regarding bank and broker-dealer net capital requirements. The idea is that banks and other financial institutions should not need to keep in reserve the same amount of capital to protect the institution (against, for example, a run on the bank) if the financial institution is heavily invested in highly liquid and very "safe" securities, such as U.S. government bonds or commercial paper from very stable companies. The safety of these securities, under this approach, is reflected in their credit ratings, as determined by certain highly respected credit rating agencies ("CRA"). In the early 1980s, there were seven NRSROs, but, due to mergers, this number dropped to three during the 1990s.

>>the SEC permits certain bond issuers to use a shorter prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimick the safety and liquidity of a bank savings deposit, but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. <<<<<<

Posted by: rc16 | April 27, 2010 3:09 PM | Report abuse

Maybe banks creating a security should be forced to purchase a rating from all the agencies (not allowing each rating agency to disclose their rating to the other until all are ready). This way, banks can't shop around. This would make securities more expensive, and the risk to the bank trying to sell the security rises with upfront costs, but this could make banks syndicate the sale of these complex deals with other banks. Lots of corporate bonds and other securities are rated by multiple agencies...is it so bad that the process to create a complex security would be a little more expensive and time-consuming?

Posted by: rglvr | April 27, 2010 3:12 PM | Report abuse

The first comment above ("Back in the days of yore, the rating was something paid for by the prospective buyer.") hits home: whatever happened to personal responsibility on the part of the purchaser?

Sellers exist to induce buying, even if a bit of puffing is involved. Free salted nuts are on bars in part to sell beverages: if you eat enough and get thirsty, you still have the choice of buying the beverage or not. Purchasers of financial instruments also have choices -- choice to trust or not to trust a ratings agency, to trust or not to trust a dealer, to purchase or not to purchase, etc.

If a ratings agency has done something fraudulent or has accepted bribes in exchange for misleading statements, it certainly should be punished; however, if it makes human error -- like make a mistake about numbers or simply be ignorant of facts -- why shouldn't the purchaser be equally responsible for failing to verify the facts?

To use a hot-button metaphor, should journalists who failed to check HCR numbers be taxed or otherwise held responsible for federal cost overruns? Should they be replaced with a public journalistic body which reports to the same employer who generated the misleading numbers? Why shouldn't we, as those who accepted the misleading numbers and took action on them be fully responsible for out failure to be vigilant?

Posted by: rmgregory | April 27, 2010 3:28 PM | Report abuse

Also,

Ratings agencies should be a reference to doing your own credit analysis. It's very hard with the MBS, ABS because you have to look at each mortgage. But if you are talking about bonds on companies, you should conduct your own credit analysis.

Also, ratings agencies are the last one's to get caught up with using new metrics or better metrics to evaluate credits. Before Michael Milkin who used different metrics to evaluate debt (methods that were then adopted by the agencies) they basically used very static balance sheet ratios. Milken incorporated operating cash flow and more dynamic metrics in looking at credits.

Posted by: rc16 | April 27, 2010 3:29 PM | Report abuse

ostap666, you know that's not what he meant. He meant that the government would potentially be more conservative than they necessarily needed to be in handing out AA and AAA ratings, thus, reletively few of them would be handed out. Then the market would have to decide if some of those products which did not receive the high ratings were actually pretty safe, or maybe safer than the government thought.

There's always the possibility that the government could do a bad job, but they certainly couldn't do worse than the status quo.

Posted by: MosBen | April 27, 2010 3:29 PM | Report abuse

For several years Standard & Poors had a contract with the Gates Foundation to rank school systems against their "gain scores" from standardized tests. For most of those years the highest gain score in Massachusetts went to a school district that regularly held back the lowest 25% of it's 9th grade, to grill them and test and retest them until their "gain scores" gained enough to take their 10th grade exam.

And so, one might reasonably think, that the same agency's data on investments might be just as suspicious.

The problem is that it is precisely those gains that the Secretary of Education intends to use to give bonuses to teachers. So much for standards, for metrics, for professionalism!

Posted by: joebeckmann | April 27, 2010 3:51 PM | Report abuse

How are the rating agencies funded in other countries? How do Switzerland and Germany apy for their agencies? Do they have something equivalent?

Posted by: Beagle1 | April 27, 2010 4:08 PM | Report abuse

Make the brokerages or Exchanges (CME) pay for them or just dump raters altogether.
Market will set a price, if any.

Posted by: beergas | April 27, 2010 4:20 PM | Report abuse

Let Consumer Reports rate bonds, just as they do cars and electronics. Whatever is lost in expertise will be more than offset by honesty.

Posted by: JONWINDY | April 27, 2010 4:24 PM | Report abuse

Problem with making the rating agencies public is Congress. Put politics or social enginerring into the mix and it will become even more confusing for the investor.

Posted by: green102 | April 27, 2010 4:28 PM | Report abuse

Jonwindy has the key... rating agencies should be independent of the entities they are rating. Strictly speaking, they work for (or SHOULD work for) the buyers, not the sellers. That is who should be paying them... perhaps as NicholasBeaudrot suggested was once the case.

But none of this matters, except at the margins, if we don't abolish the Fed.

Posted by: Observer44 | April 27, 2010 4:48 PM | Report abuse

Yes, The Buyer should pay for the rating, not the seller...or also, throw it in the market and IT decide the rating.

The problem with that though, thanks to government regulation, most (all) pension funds can't buy Junk (below BBB). There is a huge premium between investment grade and junk, and if you own investment that become junk, you are screwed (can't sell, if you do, it would be at a huge discount).


Posted by: marteen | April 27, 2010 5:12 PM | Report abuse

Many good comments. The nationalization option would be a dissaster. Having the sellers pay is clearly wrong and a conflict. The buyer should be responsible for due diligence but they do a poor job. One option would be to let any firm issue a rating (just like stock analysts), eliminate the selected few. Buyers or their brokers could buy subscriptions. The market would sort it out, though it would be painful during implementation.

Posted by: skiltonr | April 27, 2010 5:28 PM | Report abuse

In response to this:
"USDA inspectors test grains and cotton, both of which have derivatives, called commodity futures, tied to them. So why not public raters?"

Just a couple of quick thoughts.

yes we have USDA inspections. And we routinely have massive e coli outbreaks too. I seriously doubt that unionized, can't ever be fired, over paid, under worked federal employees will do the job better than private sector employees.

next, When the government owns this the potential for wrong doing increases. We're watching breathtaking scandal at virtually every level of government now. there is absolutely no reason to believe that the government will be a better source of reliable information than what we have today.

Finally, what happens when congress gets its greasy hands on this? It seems to me that the opportunities for crony capitalism would abound.

Posted by: skipsailing28 | April 27, 2010 5:28 PM | Report abuse

You're absolutely right Ezra.

There are just some things where the free market problems (ones long established in economics) are just too great, and it's more efficient (or vastly more efficient) to have the government provide it.

Sometimes the amount of government regulation and monitoring necessary is just too difficult and costly, and it's cheaper and better to just have the government perform the service directly. This is very analogous to a big issue when I was in MBA school at Michigan in the 90s. When do you do something in house and when do you contract it out. There are pros and cons, but some of the cons are the costs of monitoring and coordinating with a subcontractor not on premises that you don't have complete control over. If this con is too big it's more efficient to do it in house – in the case of asset rating it's more efficient for the government to do it in house.

A lot of the problem, though, is that the right and libertarians so hate the government doing anything (and they've done a lot to convince the public that the government is always more inefficient despite long established economics to the contrary), that they will devise these grossly costly, complicated, fragmented, low economies of scale, low economies of simplicity, and otherwise inefficient Rube Goldberg schemes to avoid the government doing it. A great example is the middlemen student loans. Doing all of the loans this way cost over $200 billion more per decade than if the government just issued the loans directly. Thankfully, finally the Democrats got the votes to end this.

Posted by: RichardHSerlin | April 27, 2010 5:43 PM | Report abuse

Of course they should be nationalized. S&P and Moody's and the rest are almost useless. I remember way back more than 20 years ago, S&P rate the public utility in my State, Washington Public power service or WPPS, a gold star up until a few weeks before it defaulted on public bonds for nuclear power in my state. It was clear more than a year before the default that these nuclear plants were destined to lose money, lots of money. The local TV station ran a program on the fiasco, again a full year before the default. Yet the bond rating never budged. So what is there usefulness? Nuttin'.

There needs to be standards for assessing the risk of financial instruments and those instruments need to be rated by a completely unbiased agency. I fully understand that government regulatory agencies also receive pressure from political sources, but compared to what we have now, it is still far better. Not perfect, but lets not make the perfect the enemy of the good.

Posted by: RedRat | April 27, 2010 5:44 PM | Report abuse

Why not a tiny surcharge on each exchange transaction to compensate the existing ratings agencies? This would remove the conflict of interest and allow them to do their work independent of either buyers or sellers. Attempting to bribe a rater should open the bribe offeror to both criminal prosecution and civil suit.

Posted by: fhallett | April 27, 2010 6:12 PM | Report abuse

If consumers have accurate and timely information, the market itself should rate securities. To that end, instead of having centralized ratings agencies, why not subsidize the services of analysts? Or even have a national security consulting agency that will provide analysis of securities on commission, but at a subsidized rate.(Thus ensuring that the agency gets all the business and guaranteeing an agency incentive to do a good job)

The point being that the rating of a security needs to be funded by the buyer not the seller, and since it is socially beneficial that we have more market information, we should pay to make the cost of that information as low as possible.

With one caveat: we can't make these analyses free or public. If they cost nothing to commission or are public initially, then there is no incentive for the buyer to pay for it. Maybe a public securities consultant would be required to make their analysis public after a certain period of time, a month or 6 months. The information would eventually become public domain, but it would still give an advantage to the payer.

Posted by: zosima | April 27, 2010 6:23 PM | Report abuse

typical posed question for statists/statism...

we need a middle of the road nationalization of everything....not too much government ownership of the means of production....not too much government controls of the means of production...not too much regimentation and centralization...not too much arbitrary administrative law and laws.....

Gee..didnt we Americans fight against this in WW2 and the Cold War??? and didn't "we" win???????????????????????

guess not......

Posted by: ChrisBieber | April 27, 2010 6:33 PM | Report abuse

The problem is that there will be a Republican President some day. This is usually the problem.

Note that the SEC didn't do significantly better than the ratings agencies during this latest bubble.

I think ratings agencies which don't have to compete for business might be better than the SEC. It wound't be democratic. This is the point. In practice, in our democracy, our elected leaders usually serve special interests in exchange for campaign contributions and cushy jobs for the boys.

Private firms with no serious competition occasionally do something useful -- for example the Washington Post corporation hired you.

What incentive to SEC employees have to work ? Now they do work and many work very hard, but it is from pride and public spirit not fear.

Now I don't propose we trust in public spirited civil servants at the SEC resisting the next Cox *or* in employees ratings agencies who dream of the glory days of the 70s when they were respected (by the few people who know what they were). I think it is possible to force raters to put their firms' money where their mouths are by requiring them to write CDS on 0.1% of the securities they rate AAA and 0.01 % of those they rate AA etc.

Posted by: rjw88 | April 27, 2010 8:37 PM | Report abuse

The problem is that there will be a Republican President some day. This is usually the problem.

Note that the SEC didn't do significantly better than the ratings agencies during this latest bubble.

I think ratings agencies which don't have to compete for business might be better than the SEC. It wound't be democratic. This is the point. In practice, in our democracy, our elected leaders usually serve special interests in exchange for campaign contributions and cushy jobs for the boys.

Private firms with no serious competition occasionally do something useful -- for example the Washington Post corporation hired you.

What incentive to SEC employees have to work ? Now they do work and many work very hard, but it is from pride and public spirit not fear.

Now I don't propose we trust in public spirited civil servants at the SEC resisting the next Cox *or* in employees ratings agencies who dream of the glory days of the 70s when they were respected (by the few people who know what they were). I think it is possible to force raters to put their firms' money where their mouths are by requiring them to write CDS on 0.1% of the securities they rate AAA and 0.01 % of those they rate AA etc.

Posted by: rjw88 | April 27, 2010 9:18 PM | Report abuse

Ezra you are right again. Why not have the SEC guys do the ratings between watching porn. And I am sure that they will not be influenced by a call from Barney Frank or the other yahoos in Congress when they call to get a good rating for the "right" nusiness. Why not just nationalize all businesses and then ratings will not be necessary. They will all have the triple A rating of the US government until the whole socialist mess goes down the toilet. Keep up the good ideas.

Posted by: acahorvath | April 27, 2010 9:35 PM | Report abuse

Ezra you are right again. Why not have the SEC guys do the ratings between watching porn. And I am sure that they will not be influenced by a call from Barney Frank or the other yahoos in Congress when they call to get a good rating for the "right" business. Why not just nationalize all businesses and then ratings will not be necessary. They will all have the triple A rating of the US government until the whole socialist mess goes down the toilet. Keep up the good ideas Ezra.

Posted by: acahorvath | April 27, 2010 9:37 PM | Report abuse

Hmmm, I wonder how foreign governments would feel about being rated by a unit of the US government?

Posted by: NJDave | April 27, 2010 9:44 PM | Report abuse

Ezra, I've been having this same thought myself, and this is the first time I've seen someone else write about it. It seems like the biggest challenge would be insulating the raters from political influence, but I don't think that's impossible. Is anyone in congress actually talking about this?

Posted by: ChicagoMike | April 27, 2010 11:19 PM | Report abuse

The problem w/ a government ratings agency is, first, that there is no reason to think that a govmt analyst will do a better job than the "cheap analysts" hired by stripped-down ratings agencies. Second, if the govmt agency screws up, the taxpayers may be on the hook - after all, a govmt AAA is like a guarantee. And govmt workers can be subject to pressure as well - look at Fannie and Freddie. A better system would be to require brokers to pay for an analysis, have the ratings agencies bid for the job (the broker doesn't get to pick), and the rating is made public whatever it is. This would avoid cherry-picking friendly raters, and prevent brokers from hiding unfavorable ratings. It would also mean that brokers would need to hire analysts to do pre-rating analysis so they don't produce some public dogs that would be hard to sell or justify. Regulated private firms are the best way to go.

Posted by: AWLinNC | April 28, 2010 12:48 AM | Report abuse

There are a number of things that could be done to make the ratings agencies 'better'.

For example, the airline have to report their on-time percentage as defined by some rule.

These guys could be forced to do the same for how accurate their ratings are. Maybe by downgrades over a 3 year period? 5 year period?

Another way would be to measure within 5 years how many of their rated bond issues were downgraded tied to a financial penelty? The raters could be forced to post a bond of some size for each rating they issue (in proportion). For each notch downgraded within say 5 years they would lose a portion of that bond. If the bond issue default they would loose the entire bond.

I'm sure other people could come up with other ideas to force them to become better at what they do.

Posted by: AnonymousAlso | April 28, 2010 7:31 AM | Report abuse

I'm with those who are skeptical. Rating governments is absolutely one of the most critical functions of ratings agencies, and would be compromised by nationalizing the agencies.

Posted by: jeffwacker | April 28, 2010 9:16 AM | Report abuse

The prospectus statements that are provided to the rating agencies as the basis for their ratings are all prepared by bond counsels and CPA firms and they get a lot of money for that. Look for their misrepresentations and go after them. They probably have insurance too.

Posted by: kay_sieverding | April 28, 2010 9:18 AM | Report abuse

Yes, nationalize the rating agencies so that they can be as honest and transparent as Fannie and Freddie......and as effective as the SEC.

Government run = political decision making, which, more often than not (witness Fannie and Freddie), leads to BAD economic decisions.

But keep on blowing the BIG Government pipe, Ezra. You and your fellow travelers will speed the day we here in the US are Greece or Portugal or (Obama's favorite) Spain

Posted by: hartwr1 | April 28, 2010 3:41 PM | Report abuse

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