Yesterday the SEC rolled out a bunch of new rules and proposals meant to purge conflict of interest and ineptitude from the credit-ratings agencies—that group of companies whose greatest hits include considering Enron investment-grade until four days before it went bankrupt and, most recently, the “AAA-rated” CDO.
The SEC’s approach is multi-front: to promote competition by broadly sharing information structured finance issuers provide to individual agencies, to require more disclosure in an attempt to prevent issuers from shopping for the best ratings, and to decrease the government’s own reliance on rating agency opinions. The SEC is also considering getting rid of the rating agencies’ liability exemption. A federal judge is making progress on that front, too, in a case that has started to chip away at the long-time defense that ratings are a form of free speech and companies that issue them can’t be sued even if those ratings turn out to be ridiculously wrong. The California AG has also launched an investigation into the ratings agencies, but he’s said he’s not really sure if he has the authority to go after them, so let’s backburner that development for the moment.
This is all progress, and that’s great. But I can’t help but wonder if we aren’t blowing an opportunity to do something bigger here. It’s hard to argue with increasing transparency and accountability and competition—even though increased competition among bond raters doesn’t necessarily do anything to increase the quality of ratings, as we’ve seen in both research and experience (there are 10 ratings agencies, but you only ever hear about 3 of them).
The real problem goes to the very heart of the issuer-pay system. A rater that is beholden to the firm producing the thing to be rated is a fundamentally flawed concept. And we all know that. We all understand that these reforms are simply meant to make a bad system less bad. We live with that because the other obvious option doesn’t necessarily seem better. Plenty of commentators have thought back to the halcyon days of investors buying ratings directly, but there is such a vast public good in having ratings that anyone can see, in having ratings that (hopefully) warn the entire investing public when trouble is brewing, that the idea of going back to a system of privately purchased and held ratings seems questionable—and definitely not worth the high transaction costs.
There, is, however, another way. We could create a disinterested third-party to mediate the relationship between issuer and rater. A number of people have suggested creating such a body, which could be either governmental or collectively controlled by the nation’s largest institutional investors. A group of finance experts at New York University have sketched out one version of how such a system would work:
With respect to the rating agency’s business model of “issuer pays,” the SEC should create a department that houses a centralized clearing platform for ratings agencies.
- A company that would like its debt rated goes to the centralized clearing platform. Depending on the attributes of the security (i.e., type of debt, complexity of firm and issue, whether other debt outstanding is already rated, etc…), a flat fee would be assessed.
- From a sample of approved rating agencies, the centralized clearing platform chooses which agency will rate the debt. While this choice could be random, a more systematic choice process could enhance beneficial competition. The choice would be based on the agency’s experience at rating this type of debt, some historical perspective on how well the agency rates this type of debt relative to other ratings agencies, past audits of the rating agency’s quality, and so forth.
- For a fee, the rating agency would then go ahead and rate the debt. This model has the advantage of simultaneously solving (i) the free rider problem because the issuer still pays, (ii) the conflict of interest problem because the agency is chosen by the regulating body, and (iii) the competition problem because the regulator’s choice can be based on some degree of excellence, thereby providing the rating agency with incentives to invest resources, innovate, and perform high quality work. It does, however, put tremendous faith in the ability of the regulator to monitor and evaluate the rating agencies’ performance.
It’s a radical solution, pretty far removed from the block-and-tackle approach the SEC is taking. Again, thank goodness for that blocking and tackling (it took long enough to get here). But if we want to make a real change in how the credit rating agencies work, it seems we’re never going to get a better time than now.