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Home Publications Blogs Beat the Press Commonsense on Credit Rating Agencies at the WAPO

Commonsense on Credit Rating Agencies at the WAPO

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Wednesday, 05 May 2010 05:15

And they said it was impossible. The Post followed the NYT in calling for an independent agent to pick which credit rating agency will rate a company's issues. This is the obvious and simple way to fix the basic conflict of interest involved when the company pays the rater. If the company has no control over who gets hired, then the rating agency has no incentive to lie in its assessment.

Congress was running around in circles genuflecting over various non-solutions to this problem. However, in the last couple of weeks there seems to have been an outbreak of commonsense, no doubt fueled by a Krugman column pushing the idea. I also have been pushing this one for a while, although my megaphone is not as big.

Comments (8)Add Comment
...
written by izzatzo, May 05, 2010 7:23
Commonsense funded by commoncents,
Buys not the biggest megaphone,
But random choices for criminal voices,
Who try to fund ratings with choices.

You socialist pigs who try to rig,
Free markets with shackles of shame,
Get a life, get your own gig,
Get out of mine you pig.
How to pick'em
written by Scott Dunn, May 05, 2010 7:42
One way to ensure that no bias can influence the choices is to use a random number generator. A well designed, open source random number generator can be audited and verified upon implementation.

Why not use that?
On a related topic
written by John, May 05, 2010 8:27
How do the major stock analyst firms get paid? Firms such as Columbine, Thomson Reuters, S&P, and so on?
Biases
written by skeptonomist, May 05, 2010 8:59
Having an "independent" party pick the rating company is a step in the right direction, but only a small one and there is no reason to think that it would prevent future bubbles. It does not remove the major bias in a bubble, which is groupthink, the general conviction that a particular type of security is low-risk. In this case, the justification was the idea that house prices never decline. Actually, objective persons (like Dean and some others) knew all along that this was not the case, but in a bubble clever people can usually find some spurious justification for the general euphoria.

Also, as long as ratings companies are paid to rate securities, there will be a bias toward high ratings. If CDO's had been rated correctly the bubble might have been avoided, but this would have meant much lower issuance and less money for the raters.

Another important bias is that of economists toward "free market" solutions.
the flaw in randomly picked rating agencies....
written by David Cay Johnston, May 05, 2010 11:37
There are only four ratings agencies, one of which the SEC does not recognize. And that is that one (Egan Jones) the SEC should study because it gets paid by bond buyers, not issuers.

When there are only 3 ratings agencies the conflict of interest problem remains because each firm will get a third of the business. Its financial interest will be to hold down costs, and therefore the quality of its work, so as to not be an outlier in either ratings or costs.

Opening up the system so we had 20 or even 100 ratings agencies would result in more reliable results.

Better yet, pick three ratings agencies at random and then track and publish results of the quality of their ratings after bonds become seasoned. Intervals of 3, 5, 10 and 15 years would suffice.

Even better, clawback fees from agencies whose ratings prove unreliable and use that money to pay bonuses to agencies whose ratings stand the test of time. The money could come from a tiny levy on bond trades.

There is no natural barrier to entry in this business. But there is a huge barrier to entry that the government has erected. That barrier is at the core of the problem.
That will not solve the probem
written by Aditya Savara, May 05, 2010 11:57
1) Your solution does not work: In your proposal, the rating agency which gets picked still gets paid even if they do a bad job. They will still have no incentive not to give inflated ratings. Probably, many would still give inflated ratings since then more people will like using the industry. So it is not a good solution.

2) Conflict of interest is not the problem: We have the same issue with universities, we pay to get grades. However, universities cannot give too many good grades, or their reputation will go down. The issue is that this second step is not occurring. This second step is what creates healthy competition in a "grading" industry.

3) Your proposal is actually even worse than the current situation! Because buyers could not choose providers, leaving no mechanism for competition. The correct solution should have all of the following: a) accreditation, just like for universities b) removal of the "big 3" oligopoly, to foster competition c) Fortune magazine, The Economist, etc. should study the history of the all rating agencies and make them public -- just like U.S. news ranks the universities. Presto, once their reputations are on the line and are public, they'll have to give good ratings. And then, if they are really good, they can charge higher prices too -- since the market will pay a premium for better ratings. I.e., if I am buying securities, a rating from a less reputable rating agency will make me pay a lower price for them, since I will consider risk.

In short, I assert that for the above reasons, a free market solution is actually the best. BUT, it requires one or more institution to publicize a ranking of the rating agencies and their track records. Of course, if you are the Economist or Forbes, I am sure your readers would appreciate that anyway.



The SEC outsourced ratings
written by skeptonomist, May 06, 2010 9:50
Here is an interesting historical account of the role of ratings agencies (via Kevin Drum):

http://rortybomb.wordpress.com/2010/05/05/an-interview-about-the-ratings-agencies-with-jerome-fons/

Note especially: "They [the SEC] essentially outsourced the critical function of independently determining risk to these private institutions." As Jerome Fons
explains, the private agencies worked well for a while, but this may have only been the time it took for people to figure out how to game the system and how much money they could make by doing so. The question of a "public option" is brought up, but is waved away with no real consideration by the two insiders (former employees of ratings agencies) involved in the interview.
public accounting firms should be rotated as well
written by jeff hooke, May 11, 2010 8:46
Not only should credit rating agencies be selected at random, or by an independent entity, but accounting firm as well for public companies. This will go a long way toward preventing the accountants from bending over backwards to please clients and skirting the intent of the rules.

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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.

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