Okay, so maybe that’s not entirely fair. The SEC has signed off on some new rules and proposed some additional ones to try to temper conflict of interest at the companies that told us all those new-fangled mortgage-related securities were unlikely to ever go bad. Oops! And now SEC head Mary Schapiro is talking about yet another batch of rules that would specificially target ratings shopping—the tendency of debt issuers to pay for ratings from companies that tell them (and potential investors) what they want to hear. In front of the House Financial Services Committee this morning, she said she’s creating a special branch of examiners dedicated to overseeing ratings agencies.
Great. This is much more than the Obama Administration’s meager response. Although, unfortunately, none of it gets at the larger issue of how dependent our financial system is on ratings agencies. And nefariously so. Why do we call Moody’s, S&P and Fitch “agencies”? They’re profit-seeking companies acting in the best interest of their shareholders… and yet when one of them says a piece of debt issued by a corporation or a city or a bankruptcy-remote special purpose entity is likely to default at a particular rate that opinion carries the weight of a government imprimatur. More than a year ago Justin wrote that maybe part of the solution is undoing this ratings dependence. Everyone from pension managers to mutual funds to bank regulators to the Federal Reserve depend on ratings agencies to tell them how decent certain bonds are. They shouldn’t.
What would be the alternative? Well, see, that’s where everyone trips up. Because to not depend on the small group of companies we’ve all agreed to depend on, market participants are going to have to start coming to their own, independent judgements. If that sounds like it costs money and requires some level of expertise, that’s because it does. Professional investors would have to professionally invest. Regulators would have to regulate. And that’s all so difficult.
There has been a lot of talk about problems with the issuer-pay model—the fact that the people issuing the debt pay to get it rated. Paul Kanjorski, the Congressman who chairs the House of Representatives capital markets subcommittee, has recently stirred up that argument, partly, it seems, because David Einhorn is shorting shares of Moody’s. It’s a fine thing to talk about, reforming issuer-pay, but let’s not lose sight of two things.
First, if you make investors pay for ratings, you’re swapping one set of conflicts for another. Investors have a desire to own highly-rated bonds just like issuers have a desire to sell them. Maybe investors wouldn’t color the judgment of ratings agencies as much as issuers—but switching from one to the other doesn’t magically get rid of the entire problem.
Second, we shouldn’t be beholden to ratings agencies in the way that we are. Bloomberg recently had a story about how the Federal Reserve’s TALF encourages ratings shopping—the very thing the SEC is now targeting. It’s a complicated, mixed-up world out there in ratings land, and the only thing that will really start to extricate us from it is to simply care less about the opinions of Moody’s, S&P and Fitch in the first place.