Today the Senate passed a tough amendment to deal with one of the most vexing problems out there: The ratings agencies.
As Jim Kuhnhenn of the AP explains the rule would basically establish an independent organisation to assign an agency to a given debt deal in an attempt to eliminate conflicts of interest.
It’s sounds as though there’s still a lot to work out, but we like it, as it’s very close in spirit to our suggestion that we proposed last October, which we’re going to print in full below.
Everyone seems to agree that the ratings agency system needs reforming, but nobody seems to have any idea how to do it, probably because there’s so much confusion about the problem.
It’s a big misconception that the problem has something to do with the pay-to-play model. The idea that the ratings agencies were compromised because they were paid by the debt issuer makes some logical sense, but in reality, all those AAA ratings were the result of buyers looking for zero-risk products, and a desire to manufacture them.
For clear reasons we can’t go to buyer pays, because then all the buyers would have different ratings, and that’s problematic since ratings are used for regulatory purposes (i.e. you have to show that you’re holding a certain percentage of your assets in AAA-rated securities). Besides, in the age of electronic media, there’s no easy way to have a business model just selling research.
Another problem is the cartel aspect — S&P, Moody’s, and Fitch are insulated from competition, but then, you can’t just have anyone rate debt, because then you get Tom, Dick, and Harry’s Ratings Agency Shop putting AAAs on everything.
So here’s the answer.
You create a pool of 10 companies licensed to rate debt. When an issuer wants to bring a security of some sort to market, they tell some central body, and a rater is selected at random from the 10. There’s no changing it once a name is selected. Thus the debt issuer can’t go ratings-agency shopping if they’re worried about what kind of ratings they can get.
If a debt issuer isn’t happy with who they got, then, well, too bad. Over time, you’d give companies that showed a good track record a heavier weight in the pool, so that they’re selected more often. Their only goal would be to increase market share by being accurate. Pandering to either buyers or sellers would be 100% impossible.
Now granted, it wouldn’t be perfect. Performance measures would be backwards looking, and you’d probably end up with companies that had gotten lazy, and stuck to old ideas about how to rate debt, but that’s just life. They’d lose their weighting in the pool, and eventually you could even put companies on probation if they got bad enough.
Nothing’s going to change the fact that incumbents grow dumb and slow — but at least they’d have an incentive to avoid that, whereas currently they don’t (have the top raters lost any market share? No.)
There’s your solution.
Business Insider Emails & Alerts
Site highlights each day to your inbox.