The Trouble With Ratings Agencies

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- The European Union has unveiled its much-discussed credit ratings agency reform plan. This comes on the heels of a blunder wherein a major agency accidentally sent an email announcing a downgrade to France's credit rating. (Similarly, the same rater made a $2 trillion math error when assessing the U.S.'s credit worthiness in August.)

The EU's proposed plan involves mandating a rotation of the credit raters issuers use (almost always Moody's, Fitch or Standard & Poor's). Further, it would allow investors to sue credit ratings agencies and it would mandate they make their rating criteria clear. Meanwhile, America's Dodd-Frank Act has two highly contradictory sections attempting to reform the raters.

While some of these reforms have merit, none target what is in our view a key problem -- the issuer-pays model. Most (save for Dodd-Frank section 939) presume the problem is not enough regulation. But in fact, a major reason the oligopoly exists is this regulation-created issuer-pays model limits the market's ability to self-regulate.

Built-In Bias

Why is issuer-pays a problem? Imagine you were required to buy a credit score from one of the major credit bureaus (Transunion, Experian or Equifax). Which would you choose? Assuming you're an overall rational consumer, you would likely find the one willing to give you the best score at the lowest price. Maybe you would put them in competition. But since you're the consumer, the credit bureaus would more or less seek to capture your business -- and might be willing to overlook a few nasties in the process.

Now snap back to reality: That's not how the consumer credit scoring business works. There, companies extending you credit pay for your rating. (You may occasionally have to buy their report, but the rating has already been tabulated by that point.) Meaning, the numbers are what they are, for better or worse, and they are a fairly accurate reflection (with the occasional error) of your personal credit history. And the ultimate user of the rating pays for it -- not the rated.

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.

This smaller credit rating agency may have a valid point. But considering the size of the municipal bond market, and the lucrative fees they potentially stand to earn by winning business from municipalities seeking a better rating (and the generally lower interest rates following that better rating), it's fair to question whether their view of S&P's and Moody's methodologies is legitimate criticism or merely a sales pitch. If all raters had to compete for investors' bucks and not municipalities', then investors could choose whose methodology and rating they believe more valid.

Historically, ratings agencies have argued the speed of modern communication means their ratings would be near-instantaneously disseminated beyond their subscriber base, jeopardizing their profitability. Which raises a separate question: Should the government regulate the raters to profitability?

Competition on a more transparent basis -- going straight to investors, not issuers -- is, in our view, vastly preferable to the current flawed system. It is not a panacea eliminating all errors and fixing all the regulatory wrongs involving the credit ratings agencies. But it would be a giant step forward.

If you're trying to benefit investors, then make investors pay for the benefit if they so choose. The alternative -- the current system -- is far from a free lunch, as poor quality ratings arising from an internally contradictory system serve absolutely no one well -- except the big three raters.

This article constitutes the views, opinions, analyses and commentary of Fisher Investments as of November 2011 and should not be regarded as personal investment advice. No assurances are made Fisher Investments will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

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