Yesterday, I asked what we should do about the fact that ratings agencies were so drastically underestimating tail risk of the securities they rated.  Today, Joe Wiesenthal at Clusterstock offers a possible solution:

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.


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