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.

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