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Home Publications Blogs Beat the Press Ending Rating Agencies' Conflict of Interest Is So Simple Even an Economist Can Do It

Ending Rating Agencies' Conflict of Interest Is So Simple Even an Economist Can Do It

Thursday, 22 April 2010 19:38
The NYT reported on how the Senate's Permanent Subcommittee on Investigations was struggling to find ways to remove the inherent conflict of interest that arises when a bond rating agency is paid by the company for whom it is doing the rating. Actually, there is no need for much struggle here. If the selection of the rating agency was assigned to a neutral party, like the Securities and Exchange Commission or the stock exchange on which the company is listed, then the agency would have no incentive to tilt its report in favor of the company. It would have been appropriate to point out that there is a simple and obvious solution to this problem, but that that the Senate for some reason is not interested in pursuing it.
Comments (10)Add Comment
written by richard, April 22, 2010 9:30
Okay here's how it should work... A small government or private agency is started. Its sole purpose is to distribute products that corporations want rated. Rating agencies, must be licensed by the government. When a corporation wants a product rated it gives it to the distributing agency, who turns gives it to the various rating agencies annomyously. The products are rated, then the government agency tells the corporation what the rating of their product is.
written by izzatzo, April 22, 2010 10:02
Any economist knows that the essence of neutral ratings is competition. As long as rating agencies compete with each other, they will drive ratings to their highest valued use for the lowest cost, just like the production and consumption of widgets in competitive markets.

When the marginal cost of a rating exceeds its marginal benefit, no more ratings will be produced and consumed from that rating agency and so on down the line until all possible ratings are exhausted and the market for ratings clears in equilibrium for an optimal ranking and number of ratings.

When another round of ratings is required, the rating agencies bid against each other in an auction for the highest ratings to be given, and the winner gets the business for rating that particular round of bond issues.

The only reason the Senate is struggling with this is because none of its members have ever seen an auction from the outside in, and have no idea how it works.

Senators are bought and sold like widgets and ratings, and from that perspective on the inside looking out, everything looks neutral to them. There's no conflict of interest, since each Senator gets whatever the market will bear, no more, no less, just like everything else in markets.
written by scott, April 22, 2010 10:45
awww, you both miss the point. The effect of the gov't entering into the equation is to indemnify the rating agency. Once the gov't approves you, you won't be able to sue or do anything.

Izzazzo, you've misapprehended the market too. Ratings agencies don't do anything, that is the lowest marginal cost; they enjoy gov't indemnification/certification and sell the brand.

The ONLY way to put teeth in to the matter is to put fiduciary duties on the ratings agencies for anyone who subscribes. Require them to acquire E n O and the insurers will vet these firms. The real pressure is the ability to sue them for failure to do due diligence. That's why economists are often poor at crafting policy. You have to make material damages that will stick--that's how you craft policy.
Martin Weiss showed the way long ago
written by JBG, April 23, 2010 11:25
Many years ago now, Martin Weiss began rating insurance companies. His innovation was to sell ratings to customers who need the information rather than sell rating service to the companies. Back in the S&L crisis, his ratings were accurate while many people lost money because of their faith in the big name agencies.
Weiss reference
written by JBG, April 23, 2010 11:44
Weiss warnings of 1990s insurance company failures:

A 1994 study by the U.S. Government Accountability Office (GAO) concluded that Weiss Research far outperformed all of the nation’s major rating agencies, including Standard and Poor’s, Moody’s and A.M. Best, in warning of future life and health insurance company failures, including the failures of Executive Life of California, Executive Life of New York, Fidelity Bankers Life, First Capital Life, Mutual Benefit Life of New Jersey, and others. Source: U.S. Government Accountability Office (GAO) — Insurance Ratings: Comparison of Private Agency Ratings for Life/Health Insurers."
written by skeptonomist, April 23, 2010 12:49
Many of the buyers of ratings would be those, like brokerages and mutual-fund managers, who have an interest in rising markets. They may want to identify real dogs, but the better things look overall the better for them.
Neutrality is hard
written by paul, April 23, 2010 2:18
You need people who are really good doing the ratings, but at the same time you need to prevent them from getting subsequent jobs with any of the companies whose product they rated. I think that holding rated issues to maturity (and not being allowed to purchase CDS on them) might be the only way.
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.