Three Suggestions for Reforming Rating Agencies

Economists have offered all sorts of competing theories about exactly what went wrong to cause the financial crisis. Those theories place the blame on lots of different parties. But the one thing that most everyone agrees on is that the credit rating agencies should shoulder some of the blame. Oddly, however, the rating agencies seem to have been of little concern in the Obama administration's regulatory suggestions released earlier this week. I have three suggestions for reforms Washington might want to consider.

Before getting into those suggestions, what exactly did Obama's financial regulatory proposals recommend for the rating agencies? According to a Reuters article:

The plan urges Moody's Corp's Moody's Investors Service, McGraw-Hill Cos Inc' Standard & Poor's and Fimalac SA's Fitch Ratings and others to bolster the integrity of their ratings, especially in structured finance.

It also calls for reduced conflicts of interest and for regulators worldwide to tighten oversight.

But the blueprint does nothing to address what critics call the industry's key shortcoming: That the biggest agencies are paid by issuers whose securities they rate, creating an incentive to win more business by assigning high ratings.

Those seems like pretty broad strokes to me. Essentially, they have to explain their assumptions better. This doesn't seem to scream: "Problem Solved!" In that same Reuters article, Jonathan Macey, deputy dean of Yale Law School sums up the implications of the new regulations well:

The overall impact of existing and proposed regulatory changes on rating agencies is extraordinarily easy to summarize: They reward abject failure.

I agree. But I'm not sure I buy into the solution that many stand by, described at the end of my first block quote above. It's easy to complain that issuers shouldn't be the ones to pay for the ratings, but now else do the rating agencies get paid? Do you rely on investors? The problem here is that investors can't decide which rating agencies should rate a deal before they buy the securities; they buy those securities at least partially based on what those ratings are. It's a nice little catch-22. One way or another, the issuer needs to decide which rating agencies to use, which can always result in shopping around for the best ratings.

I don't pretend to have a definitive solution to the rating agency problem, but I have three suggestions that might be interesting to consider.

Maybe Rating Agencies Need Some Skin In The Game

One of Obama's new financial regulations would require that mortgage issuers have some skin in the game and keep a portion of the mortgages they originate. I explained that this solution seems nice in theory, but in practice these originators had plenty of skin in the game already. It didn't help. But if you are a believer in this logic, then maybe rating agencies should also have some skin in the game.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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