Rating Agency Frankenstein or Performance Solution??

On a scale of 10 (best) to 1, the performance of the major credit rating agencies in the years leading up to the bursting mortgage security bubble earned a 0, and that is generous.  Most, this blogger included, assign much of the blame to a fee system in which the issuer of a proposed security is responsible for selecting the rating agency and paying the fee.  The same basic conflict is inherent in every deal, give this security a high rating or I won't come back next time.  To compound the inherent conflict, the fee is due only if the rated security is actually issued, an aborted deal (which can be caused by a lower than expected credit rating) also eliminates the fee for the rating agency.  Perhaps worse still, issuers could work on a preliminary basis with more than one rating agency, then go with the agency that offered the most favorable rating.

Something had to be done.  Senator Al Franken has proposed an amendment, now approved by a rare bipartisan vote of 64 to 35, to the financial reform bill that will solve the conflicts problem, and create a lot of big new problems instead.  Sadly, we must conclude that if 64 Senators agree, they must be doing something horribly wrong.

First, the usual conflicts disclosure.  We can't bash the rating agencies for conflicts, then hide our own. Regular readers recognize these disclosure  “therapy sessions” include an element of humor – thank God no Christian Brothers involved in this one-but some of this stuff might actually effect my outlook and blogging performance.  So.....I'm crazy about Al's old “I, Al Franken” SNL routines.  Hated Stuart Smalley.  Love the fact that an ivy grad, comedy writer/performer and sometime stand up can get elected to Senate.  I will be in the next NJ primary.  I do not like public utilities, although I accept them as a necessary mediocrity in some industries.

Unburdened, we consider what  the Franken amendment will do.  First, create a new Federal agency – ouch, never a good start.   Next, make it part of the SEC – the same SEC that got a pre-crash performance rating of  “-1” while the credit  rating agencies earned their “0”?  Now, let the new government agency assign all work to the credit rating agencies, that's right – whenever someone wants to issue a new security the new government  agency will tell them which credit  rating agency they must use.  No more rating shopping, no more implicit pressure from that inherent conflict.  But there are some huge buts.

How about fees.  The credit  rating agency will have a captive customer, a mini-monopoly, created by government fiat, so it can charge whatever it wants, up to the point where the issuer says it will go to market with no rating whatsoever – a dicey and difficult proposition in today's universe.  Solution -.  new government agency sets fees.  How about allocation of work.  Right now there are ten rating agencies registered with the SEC: Moody's, S&P, Fitch, and the seven dwarfs.  Will the new government agency give equal assignments to each of the ten?  If so, the value of the seven dwarfs just went up one hundred fold by government fiat.  Can I start a new credit rating agency, register and get one out of every eleven assignments, beginning on Monday?  Guess the new  government agency will decide.  We have stripped the credit rating agencies of the incentive to rate too highly, but have we also stripped them of the incentive to work well, to work fast, to work hard?  If assignments and fees are all determined by the new government agency, then it would seem so.  Sounding more and more like a public utility?

Better alternatives if you wan to incent performance from the credit rating agencies:  1) Let the securities buyers pay for credit ratings instead of the issuers and forget all this new Federal agency stuff.  In some ways this is a return to prehistoric times, with lots of new logistical problems, but a smart guy like Al might find a way if he started working on it from this angle.  2) Keep the existing “market” system (issuer picks and pays the credit rating agency) but eliminate some sources of conflict – the credit rating agency gets paid even if the security is not issued and the issuer has to lock into one credit rating agency early on – no ratings shopping.  The result still has that big, inherent conflict, but it's very similar to the CPA's inherent conflict – keep the client happy but still make sure that any certified financials are kosher, er GAAP.

Photo Credit: Dano