The Trouble With Ratings Agencies

You might think no one would establish a business where the rated pays the rater to rate. Yet that's exactly what the issuer-pays model is. Through a series of congressional edicts, corporations, municipalities and some sovereigns pay credit raters to assess their bonds when issued. That presents a bit of a conflict of interest, in our view -- one subsequent legislation hinging on debt ratings (for example, bank regulation involving asset quality determined by ratings) has likely only made worse.

Bond investors do not currently have a choice to place either a high, low or no value on credit ratings agencies' opinions. The decisions whether to rate and which rater to choose have occurred before investors ever step into the equation. This despite the fact ratings were mainly designed to benefit precisely these investors. Ultimately, those individuals should be given the choice: Do you value a rating? Which would be an easy enough system to enforce. Make credit ratings available for purchase by investors directly. Voila! Market-oriented reform.

Benefit for Investors

The ultimate result of this user-pays system? It's likely the raters' error rate improves. After all, if there's no regulatory force pushing a municipality (corporate or sovereign) to buy a rating, then raters have to market a product based on things like quality. And pricing. And the amount of quality an investor can get for a certain price. Errors, like mistakenly emailing a downgrade, would likely be punished by subscribers leaving. No angry politician finger-wagging required. They'd probably simply make less money, and that's that.

Moreover, removing this buy-your-own-rating structure likely increases the viability of competitors. How so? The current structure incentivizes competition among credit ratings agencies for bond issuers' acceptance. Thus, when a ratings agency criticizes the methodology of another, the ultimate ratings user (investors) could easily characterize it as a sales pitch.

For example, a small credit ratings agency has released a report showing for the past 40 years, S&P and Moody's have potentially underrated municipal issuers. They stated S&P and Moody's methodology is based on Great Depression default studies. However, this smaller agency's report shows the majority of then-defaulting municipalities wouldn't today -- because Depression-era defaults were largely driven by seizure of municipalities' deposits at failing banks. The legal structure and safeguards are now quite different -- meaning deposit seizure is vastly less likely today.

« First ‹ Previous 1 2 3 Next › Last »