Friday, October 24, 2008

Reforming the Credit Rating Process

Recent news accounts report that employees at certain credit rating agencies sometimes knew that some of the deals they were evaluating were pigs without lipstick, and questioned the wisdom of rating them. The fact that the credit rating agencies are typically compensated by the issuers of the debt they are rating, instead of by investors, fuels concerns over potential conflicts of interest. Since many mortgage-backed securities that initially received AAA-quality ratings have since been downgraded for reasons that may have been foreseeable, the integrity of the credit rating process has become intensely important. This is particularly so since many institutional investors are required by law to rely on credit ratings with respect to some of the investments they can make.

Probably the greatest concern is the way the credit rating agencies are compensated. When you're paid by the person you're evaluating, how objective can you be? No matter how many rules and procedures are in place, will the credit rating agencies ever be willing to bite the hand that feeds them?

It would be much cleaner to have the rating agency funded by investors. There is a large community of institutional investors--mutual fund management companies, pension funds, university endowments, and so on--that has a powerful interest in disinterested and objective ratings. They also have the money to fund a nonprofit rating organization, and the market power to demand that issuers of debt agree to ratings by nonprofit rating agency.

An investor funded credit rating agency isn't as far fetched as it may sound. The credit rating process began with investors paying the fees, and it can return to that. In the consumer products arena, an independent nonprofit, Consumer Reports, stands as the most credible evaluator. Consumer Reports does not accept advertising from the companies whose products its evaluates, and it buys those products rather take free samples. By maintaining independence from manufacturers, its credibility is enhanced. If you want to find out how much pizazz a car has, you can read an ordinary car magazine. But if you want to find out the hard facts about how reliable a car is, you're better off reading Consumer Reports.

The established credit rating agencies are for profit organizations. Don't look for them to convert into nonprofit do-gooders. The buyside community (i.e., investors) will have to take the initiative to establish a new rating agency. Doing so may seem to involve a lot of work and expense. But, perhaps institutional investors could tally up their losses in the past couple of years from rated securities, and then they might see what's been truly expensive.

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