Rating the Rating Agencies

One of the more disappointing elements of the administration's proposed financial regulation reform is the absence of any real action regarding the rating agencies. After the tongue-lashing Congress gave rating agencies executives regarding the whole we'd-rate-this-stuff-if-it-were-structured-by-cows fiasco, I assumed that this would be addressed. But as Barry Ritholtz pointed out, the rating agencies were largely left out of the outline.

Although much of the criticism of rating agencies stems from the inherent conflict of interest of the issuer-pays model the big three* use, the real problem is the rating agencies' government-ordained role in the financial system. The issue is not that investors became overly reliant on on the rating agencies, but rather that the rating agencies are embedded into regulatory models, as Marc Flandreau and Norbert Gaillard point out. Mutual funds, banks, and other financial institutions all have requirements limiting what securities they can own based on how those are holdings are rated. Even if the financial institutions don't want to care about what the rating agencies say, they law says they have to.

*Standard & Poor's, Moody's, and Fitch

It's unfortunate these regulations gives so much power to these--or any other--institutions. I don't blame the rating agencies for getting things wrong, because it's foolish to expect them to get them right. You could count on one hand the number of people that actually predicted the crisis. What makes the rating agencies better at this than anyone else? If you really could, for instance, predict that Lehman Brothers would fail, you'd make a lot more money shorting the stock on your own than you would downgrading the rating while working at Moody's. Their models are essentially based on what has happened in the past**. No amount of regulation is going to improve the rating agencies -- or anyone else's -- ability to forecast the future.

** Mortgage-backed securities never defaulted--until they did.

So the problem is not reforming the rating agencies themselves, but rather reforming the system to remove their influence. The rating agencies themselves are now using the First Amendment to argue they shouldn't be responsible for what they write. If the rating agencies are now backing away from what they've said in the past, why should the government continue to give them oligopoly for the future?