April 26, 2010
A big part of the story of the housing bubble is that the bond rating agencies were willing to give issuers of mortgage-backed securities collaterized debt obligations investment grade ratings even when they were clearly junk. The explanation was that the rating agencies were being paid by the issuers, therefore they had an enormous incentive to bend their ratings. If they rated these issues honestly, they would lose their business.
The conflict of interest in this “issuer pays” system has been widely noted. Unfortunately it has prompted mostly strange genuflecting rather than serious thinking. The obvious way to fix the conflict is to take away the hiring decision from the issuer. The issuer would still pay the rating agency but a neutral party — the SEC, the stock exchange on which the company is listed, the local baseball team — would make the decision as to which agency gets hired.
Some of us have been pushing this one for a while (e.g. here and also Plunder and Blunder), but Congress has preferred much more complex regulations that would have no impact on the basic conflict of interest. However, Paul Krugman comes to the rescue in his column today. Maybe now someone in Congress will be able to think clearly on this issue.