Coming to a Consensus on Ratings Agencies

A not so trivial, but smaller piece of the financial regulation debate is the issue of ratings agencies. They certainly played a part in the crisis, misevaluating collateralized sub-prime mortgages and various securities, leading investors too lazy to do their own due diligence (most) into thinking mortgage-backed securities really were all pretty much AAA. And that was wrong.

Addressing the oligopoly of the ratings agencies is important. Unfortunately, it is being overshadowed by the systemic risk regulation debate and the derivatives debate. Not to mention executive pay. (Though it is understandable, as those are critical components of the overhaul plans proposed from various sources.) Nevertheless, it would be a shame if the rating agencies were left in the same position they are in now once the overhaul is done.

The New Yorker has a piece in this week’s issue (dated to September 28, 2009) on the ratings agency issue. In the article, James Surowiecki concludes:

Rating agencies existed long before they carried a government imprimatur, and, their recent dismal performance notwithstanding, they’ll exist in the future, if only because few investors have the patience to sort through all the bond offerings and structured-finance deals out there. But we need a divorce: the rating agencies shouldn’t be government-sanctioned and government-protected institutions and their judgments shouldn’t be part of the rules that govern how investors can act.

This is, by and large, the proposal of the GOP for dealing with rating agencies. And it’s a good idea. As I wrote in a recent policy brief on financial services regulatory reform:

GOP Plan: Eliminates all references to credit rating agencies in federal law. […]

The existence of credit ratings is perfectly legitimate and beneficial, however, they should not be turned into a federally supported oligopoly. U.S. law refers to credit ratings as a tool for setting capital reserve requirements, restricting investments and guiding the use of taxpayer money in the marketplace. However, this has reduced the need for money managers to perform proper due diligence. The [GOP] proposal, which the SEC is also considering doing on its own, would increase fiduciary responsibility.

There is no indication from the White House that they will go along with this idea yet. But it is a prudential policy proposal that may get bundled into the overhaul as part of a compromise. In any case, dealing with the credit rating agencies is important and shouldn’t be set aside. Washington should come to a consensus on this issue and act to prevent the agencies from distorting the market in the future.

Also see my previous posts on this here.

For more in financial services regulation, see the new Reason study: “Rebuilding Wall Street.”