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Should the Government Get in the Credit Ratings Business?

The Capital Markets subcommittee of House Financial Services is looking into "Approaches to Improving Credit Rating Agency Regulation target="_blank"" on Tuesday afternoon. The credit rating agencies are one part of the financial system that everyone agrees needs to improve, including the agencies themselves. (Well, perhaps not everyone - see the end of this post.) Deven Sharma, president of Standard & Poors, said in a recent Bloomberg article, "Just don't leave us the way it is today," where some federal regulations even insist that companies invest according to credit ratings. "There's too much risk of being overused and inappropriately used."

But how regulation will change is anyone's guess. Proposed solutions range from licensing individual credit raters, to making investors (rather than bond issuers) pay rating agencies to reduce conflicts of interest, to creating a new not-for-profit rating agency overseen by the government.

Of course, the idea of making credit ratings a government service evokes strong reactions. In that same Bloomberg article, Daniel Fuss of Loomis Sayles & Co., an asset management firm, says, "I would be strongly opposed to the government taking over the function of credit ratings. I just don't think it would work at all. The business creativity, the drive, would go straight out of it."

I'm sure I'm going to get angry responses to this, but do we really want creativity and the profit motive determining how bonds are rated? Crash-test studies for cars are done by the National Highway Transportation Safety Administration, part of the Department of Transportation, and by the Insurance Institute for Highway Safety, a non-profit organization funded by auto insurers (who have an interest in reducing accidents). Rating vehicle safety is a complex task that requires a detailed understanding of engineering and sophisticated computer simulations. How are bonds all that different?

There is an argument that says that product ratings - whether crash-test scores or bond ratings - can be produced by free markets. On this theory, market participants want the information contained in ratings, so someone will pay for them. Companies that put out inaccurate ratings will go out of business, and only the best raters will survive.

That's a nice theory, but it faces a couple of problems in practice. First of all, there is effectively no competition in the market today, which is dominated by three companies: Moody's, S & P, and Fitch. Second, it's perfectly rational for individuals at a bond rating company to hand out lots of good ratings in an economic boom - especially if good ratings are what your direct customers, the bond issuers, want - and then beg for forgiveness when the bust hits. Anyone who was refusing to hand out good ratings during the boom would be certain to go out of business. The incentives facing credit rating agencies are analogous to the incentives facing the rest of the financial sector, and as a result their behavior came out the same - with the results that we all know.

I'm not saying that government-sponsored rating agencies are the answer. Perhaps the solution is the one proposed by Robert Dobilas, president of Realpoint, a rating agency that is paid by investors rather than by issuers: make all information available, prior to the issuance of the securities, to all rating agencies, not just the ones who are paid by the issuer.

But you won't find the solution in the prepared testimony by Stephen Joynt, CEO of Fitch - because there's no solution in there. Let me summarize his testimony for you:

  • The credit crisis had many causes.

  • We manage conflicts of interest (being paid by issuers) effectively.

  • We disclose plenty of information about what we do.

  • If the information we get is bad, it's not our fault. ("Congress ought not to hold rating agencies responsible for such due diligence or for requiring that others do it. Rather, Congress should mandate that the SEC enact rules to require issuers and underwriters to perform such due diligence – make public the findings – and enforce the rules they enact.")

  • The existing system of government-endorsed rating agencies (NRSROs) is fine.

  • Rating agency liability should not be increased.

Seriously, Joynt doesn't recommend a single change to the existing system. Reading his testimony, you wouldn't realize we had just lived through two years in which the AAA rating had become a nationwide joke. That if nothing else should motivate people to demand change.

--James Kwak

By James Kwak  |  May 19, 2009; 12:03 PM ET
Categories:  Regulation  
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I have a question, why hasn't the market produced buy side rating agencies? I keep hearing free-marketers whinging about how the rating agencies were paid by the sell side, and that sell side ratings were required for some entities. Was there some law preventing a strictly voluntary buy side agency? Why didn't the market provide such an agency? If enough people wanted one wouldn't it have been able to get access to any offering through the value of it's product to the seller? Why did this market failure exist?

Posted by: flashrom | May 20, 2009 7:54 AM | Report abuse

I believe the suggestion that a governmental agency should be established to evaluate the financial health of of any publically traded company in the U.S. This would clearly insure an unbiased evaluation of the potential default for any bond or stock issue being sold to the public.

Posted by: rpbcorwin | May 20, 2009 3:54 PM | Report abuse

"Seriously, Joynt doesn't recommend a single change to the existing system."

Umm, yes, he does. You actually quoted Joynt recommending a change to the existing system. Joynt said:

"Congress should mandate that the SEC enact rules to require issuers and underwriters to perform such due diligence – make public the findings – and enforce the rules they enact."

In what way is that NOT a recommended change to the existing system?

I know it doesn't fit the standard line in the blogosphere: that everything everyone in the financial sector says is wrong, and motivated by a covert desire to screw the Goodhearted Taxpayers. But this blog would be a lot more interesting if it mixed in a little reality-based discussion to go with its strong doses of delusion-based commentary. Maybe the Post could add a writer who, you know, actually has some experience in the financial sector?

Posted by: MarkJ2 | May 23, 2009 11:59 PM | Report abuse

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