Should the Government Take Over the Ratings Business?

Last week, a Senate subcommittee considered the rating agency problem. Few industries have shouldered as much blame for their part in fueling the financial crisis as the ratings industry. Their mistakes led investors to believe bonds based on mortgages would perform better than they did. For some bond types, nearly all were eventually downgraded.

There are numerous suggestions of how to deal with this problem. Kevin Drum doesn't know of a good solution, but writes:

Turning the ratings agencies into regulated utilities might be better than the current situation, but not by much. And if you're going to do that, why bother with ratings agencies at all? Why not just have the SEC provide ratings?

Of course, the rating agencies are practically utilities already. They are heavily protected by federal law. They essentially can't be prosecuted for being wrong due to their ability to successfully claim First Amendment free speech regarding their ratings. The government also has set very high barriers of entry, which is why the big three remain in charge, even despite their utter failings during the housing bubble.

If there's no clear solution to the rating agency problem, should the government just take over, as Drum quips? He ultimately thinks that probably wouldn't work out too well, since poorly-paid bureaucrats probably will likely be even less likely to understand complex securities than the private sector analysts.

That would probably be a common first reaction. After all, the SEC's track record isn't great these days, having missed the Madoff and Stanford ponzi schemes, failing to act on Lehman's problems, and facing public embarrassment after a report surfaced saying that senior staffers spent their workdays viewing pornography. Can anyone honestly, with a straight face, say that they would do any better than the rating agencies did? To see a perfect example of a government-sponsored entity doing an awful job of understanding the market, one only need to look as far as the biggest of all bailout recipients of all: failed mortgage agencies Fannie Mae and Freddie Mac.

Yet, Ezra Klein thinks putting government in charge of ratings might be a good idea. He notes:

The obvious problem is that a public rating agency might be too conservative, but on the one hand, I'm not sure that's a bad thing, and on the other hand, the market could always ignore the rating.

Klein might have a point. If the government fails, then ratings might completely lose their meaning. Wouldn't that force investors to just ignore ratings and do their own due diligence? This would certainly be a great outcome. In fact, it's probably ideal. Investors should be the ones evaluating the investments they purchase -- that way they retain ultimate responsibility for the performance of their portfolios.

There are a few problems still looming, however. First, Klein must have a lot of faith in investors' willingness to work diligently. Their broad reliance on rating agencies during the housing boom, however, shows their laziness. Had they analyzed mortgage bonds themselves and took the time to better understood the market, they might have realized earlier how poor a job the rating agencies were doing in evaluating real estate-related securities.

In fact, there's an even greater likelihood that investors would happily rely on government ratings than they did private ratings: the government could be held accountable. If the government puts a quality stamp on something, but gets it wrong, people will expect it to stand behind its word. That could result in a view that bonds have a sort of implicit guarantee to perform as the government dictates. One can only begin to imagine the investor/bank bailout that would have ensued if the government had made the same mistake as the rating agencies did during the housing bubble. It would have been far more costly than whatever the cost of the bank bailout turns out to be.

And then there are the global consequences. Imagine if the U.S. government mis-rated a universe of bonds that China was heavily invested in. Can anyone begin to doubt that the government wouldn't feel pressured to "make good" on its ratings errors, for the sake of international diplomacy?

The best solutions to the rating agency problem would be those that would result in investors paying for ratings, whether through third-party research firms or by doing their own analysis in-house. Incentives need to be better aligned, competition needs to be introduced into the ratings market, and investors need to retain ultimate responsibility. Any "solution" that doesn't capture those criteria will fail.