Reforming the Ratings Agencies: The Dog that Didn’t Bark
Yesterday, President Obama made his pitch for financial reform, hitting upon four issues: (1) Too Big To Fail; (2) Opaqueness of Derivatives; (3) Consumer Protection; and (4) Say on Pay. Conspicuously absent was any mention of the need to reform the way financial securities are rated. Currently, laws and regulations have granted a virtual oligopoly to three ratings agencies: Fitch, Moody’s and S&P. These laws and regulations limit pension investors and money-market managers to investing in so-called “investment grade” securities, and defines “investment grade” based upon the ratings of these three oligopolists. Sadly, the business model of these oligopolists is fatally flawed, as they are paid by the investment bankers who assemble the often toxic securities that led to the financial crisis. The proposed legislation does nothing to change this failed business model and only serves to strengthen the oligopoly enjoyed by the three agencies.
There is a better way. Up until about 20 years ago, a similar problem existed in the U.S. market for residential brokerage services. If you wanted to buy a house, you contacted a broker who was hired and compensated by the seller of the house, and who had a fiduciary duty to the seller, but not to you—the buyer. This led to myriad problems, such as failure to disclose material problems with the house. To deal with this problem of duty and asymmetric information, we moved to a system where the buyer also hires a broker, known as the buyer-broker, who has a fiduciary duty to represent the buyer, but is paid by the seller. The brokerage fee is then split between the seller’s broker and the buyer-broker. Isn’t it time that we move to a similar set-up for the rating of financial securities?
