Mend the Ratings Agencies


Standard & Poor’s threat to lower America’s AAA rating has sparked waves of anger and prompted defenses of the rating agencies. Recently, several rating agencies heads were called into Washinton to testify in front of Congress.

Rating agencies don’t exactly have a sterling rating. Their decision to award many mortgage-backed securities high ratings was a contributing factor to the financial crisis. However, in providing a mechanism to roughly evaluate many types of bond securities, they do perform an essential function in capital markets. It may seem uncomfortable to see unelected company officials take stances on government actions and drive investor sentiment, but it does seem valuable to have some non-partisan agency perform the essential monitoring and disciplining roles that individual market participants cannot. Arguably, the ratings agencies have been far too lax in their reluctance to speak out over America’s growing debt burden before now. 

It’s hard to know where to stand on the rating agencies given the mess they face. However, the current situation does have two fixable problems:

1. End the monopoly. The question is whether rating agencies current ratings reflect honest estimates of future performance undertaken by solid analysts, or whether the reflect the deluded rantings of partisans exploiting their regulatory-granted position. Opening the market for ratings agencies to a broader set of players would increase competition and ideally move us closer to a world of reliable estimates. 

2. Reduce regulatory reliance. A big part of why some ratings are inflated is the reliance of regulators and institutions on specific indices. Exact ratings play a role into which assets certain institutions are permitted to buy, or else impact the amount of capital that has to be kept. Moving over to market-driven factors like interest rates or market based indices as many have suggested (I have some thoughts on that here) could reduce the incentives to inflate ratings for particular products, and encourage investors to do more due dilligence themselves. 

Dodd-Frank makes some progress in both goals, though as with many things in the bill the implementation remains to be seen. 

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