Reputational risk is insufficient for ratings agencies
I’ve had a few conversations recently with intelligent, informed people about the failure of the ratings agencies during the housing bubble to keep up standards on their ratings of CDO‘s. You can discuss all day whether it was individual ratings they got wrong (at the level of the MBS‘s) or whether it was the correlation of defaults they were underestimating. It was both. But in the end the fact is they sold AAA ratings.
Nobody really argues against that. What fascinates me, though, is that people sometimes still argue against the idea that the revenue model of ratings agencies, whereby the issuers of debt pay the ratings agencies for ratings, is fundamentally flawed.
Their explanation is something like this.
That system worked fine for a long time, because for a given rating they wouldn’t sacrifice their reputation on a ridiculous rating for some small-fry issuer. And the system would have continued to work fine except that the issuers became huge and the amount of money involved became too tempting and so they ended up whoring themselves. But there’s nothing fundamentally wrong with the incentive system, we just need to keep reputational risk the driving force.
What?? That’s argument kind of reminds me of the so-called dental insurance which pays for cleanings but when it comes to dental emergencies with root canals and surgeries you’re shit out of luck. That’s not insurance at all, in other words.
I see the need for ratings agencies – it’s a way of crowd sourcing due diligence, which makes sense, but only if we can trust the ratings agencies as an impartial third party. And I don’t want to seem like someone who doesn’t have faith in humanity, but my trust isn’t won by a system of perverse incentives that has already failed. Let’s just say I have hope for humanity but I also acknowledge our weaknesses.
And just to be clear, the new bond rating agency Kroll, which has been getting a lot of attention, also uses an issuer-pays revenue model. But I guess Egan-Jones doesn’t, it uses a subscription-based revenue model. I still prefer the concept of an open source ratings agency – I’ve been in touch with Marc Joffe, who is doing just that for sovereign debt, which I will talk more about in a separate post.