Rating Agency Problems and Solutions

Given the way Congress is moving on Wall Street reform (or not moving, everything on the Hill is at a snail’s pace at the moment), it’s looking less and less liking that something significant will happen with rating agency reform. And that is problematic. Don’t get me wrong, I love it when Congress moves slow. It decreases chances that damaging and wasteful legislation will be passed (i.e. The Stimulus). However, the rating agency oligopoly was a factor in what caused the financial crisis. Their government protected status, removing real competition, changed their incentive structure for how they viewed their models. While there is less trust of the big three agencies now, the status quo in the law has to change to get real reform.

But there are good ways and bad ways to change things. Last week Joe Weisenthal wrote for The Business Insider:

For clear reasons we can’t go to buyer pays, because then all the buyers would have different ratings, and that’s problematic since ratings are used for regulatory purposes (i.e. you have to show that you’re holding a certain percentage of your assets in AAA-rated securities). Besides, in the age of electronic media, there’s no easy way to have a business model just selling research.

Another problem is the cartel aspect — S&P, Moody’s, and Fitch are insulated from competition, but then, you can’t just have anyone rate debt, because then you get Tom, Dick, and Harry’s Ratings Agency Shop putting AAAs on everything.

So here’s the answer.

Wait, before I give you his idea (I guess you can just scroll past my thoughts if you really want to), I want to point something out. Why can’t we have Tom, Dick, and Harry’s Ratings Agency Shop? So what if 100 ratings groups start and begin slapping AAA on everything. We don’t have to accept TDR’s rating of AAA unless they have a proven record of getting things right. In a world of competition, on the firms that develop a track record of getting ratings right will be accepted and the rest will fall by the way side.

Here’s the problem though (and this is likely part of Weisenthal’s concern): U.S. law creates a lot of scenarios were a rating of AA or AAA is a required label. As such, it has created standards for “Nationally Recognized Statistical Ratings Organizations” (NRSROs). That is the oligopoly club, protected by the government. But if we remove these laws, as I suggested in a policy paper last month, then it wouldn’t be a problem to have random people start labeling things AAA or maybe AAAA! Only the firms that develop and protect their reputation will be taken seriously.

But to Weisenthal’s suggestion:

So here’s the answer.

You create a pool of 10 companies licensed to rate debt. When an issuer wants to bring a security of some sort to market, they tell some central body, and a rater is selected at random from the 10. There’s no changing it once a name is selected. Thus the debt issuer can’t go ratings-agency shopping if they’re worried about what kind of ratings they can get.

This does avoid the buyer problem. But there is still a collective of sorts that won’t have the right competition-driven incentives to produce the best quality ratings. I just don’t see how expanding an oligopoly from three firms to 10 solves the problem.