Regulating the Ratings Agencies: Low-Hanging Fruit?

Among all the furious post-almost-apocalyptic discussions of financial industry regulation (i.e. here, here, here, here, and here), I'm stunned how rarely people mention the single biggest leverage point: regulation of ratings agencies.

If Moody's et al had rated mortgage-backed securities properly, we simply wouldn't be in the fix we're in now. Those securities would have been cheaper and harder to sell, and as a result mortgage writers would have found it more difficult and expensive to pawn off their risks. This in turn would have forced them to be more prudent and sensible in their lending practices.

At the very least, regulators could mandate a cigarette-pack-type warning on each and every rating: "This rating was paid for by the issuer of the security being rated, and was prepared in consultation with that issuer." (The SEC seems the natural entity for this job. No need to inflate the Fed any further right now.)

This might lead market mechanisms to improve the situation: ratings that include that warning would be discounted in the market (yes, they're free, but they're quite possibly worthless), opening market opportunities for purveyors of more objective ratings.

In the big scheme of schemes being floated, this is an easy win. Why isn't anyone talking about it?

(This highlights a key area where–contrary to knee-jerk anti-regulation zealotry–government regulation is both efficient and essential: insuring that all, or at least more, information is known. Absent regulation to ensure transparency and disclosure, the market may be "free," but it's certainly not efficient. Market-generated incentives and constraints if anything encourage players to ensure that information is not known. It's a quintessential, inevitable, and never-ending "free-market" failure. This is just one example out of zillions where government-imposed incentives and constraints–regulations–make the market more efficient than the market would.)





2 responses to “Regulating the Ratings Agencies: Low-Hanging Fruit?”

  1. DAS Avatar

    Perhaps a sports analogy is in order? You can only have meaningful competition if you have referees and a clear set of rules …
    I similarly think credit ratings agencies are problematic — the decision to loan money should be based on your ability to pay which, with a few simple assumptions (you won’t get fired, etc.) is a relatively easy determination: you submit a sample budget indicating how you are going to afford to pay back the loan you’ve taken. But instead your “credit score” (computed using a proprietary method by a company making money off of information about you — that doesn’t even have an obligation to send you that information without you having to jump through hoops to request it) is somehow the basis of whether loans are extended.
    And people blame borrowers? Now as a borrower I might be able to afford to pay back a personal loan or a regular mortgage (with the people offering those loans making money on the loan), but I get turned down for those because of my “credit score”. Yet I can get a credit card with which the credit card company can nickle and dime me having me pay back the loan for ever with exhorbatant interest rates or an ARM which starts out cheap but which eventually I cannot afford?
    I’d go on, but I’m already ranting off topic …

  2. Steve Broback Avatar

    Any regulation that enhances “all information being known” — especially in such an opaque market should be embraced…