Congress is scrambling to get more information about how to deal with the credit rating agencies in Wall Street reform, but they haven’t come up with many answers yet.
Many have described the essential conflict of interest at the heart of the financial crisis emanating from the credit rating agencies, who get hired and paid by the companies whose securities they rate. Because the profit margin of the raters is based on how many clients they can hold, and because the clients want highly-rated securities so they can sell their products, this creates a situation where everyone is incentivized to slap AAA ratings on whatever crap security, and it prevents the customer from having good information about the products.
This can obviously lead to fraud, and it did. The Permanent Subcommittee on Investigations held an entire hearing about it, proving beyond the shadow of a doubt that the rating agencies succumbed to pressure from the biggest financial firms.
But the question remains, what can you do about it? In an interview with FDL News, Sen. Jeff Merkley didn’t have much of an answer. He agreed about the nature of the problem. “It’s like buying a house, and having the seller choose the appraiser. The buyer of the house wouldn’t agree to that, and neither would the bank.”
But he didn’t offer much in the way of a solution. “I keep asking people, ‘How do we fix this?’ There hasn’t been enough work done on it yet to come up with a solution.” That’s something of a shocking admission. The problem of the rating agencies could be divined simply by looking at the facts of how they make their money and what the incentives are.
Merkley continued by offering some ideas on how to change the financial incentives. He proposed putting the fee on the buyers of bonds rather than the sellers, and randomly assigning the rating to a qualified agency. “Maybe that would separate the seller from the rater,” he said. He also offered the idea that all the agencies could split a percentage of the business on rating bonds, taking the profit motive out of the process.
These approximate, though not exactly, the idea of Dean Baker, of The Center for Economic and Policy Research. “All you have to do is take the hiring decision away from the issuer,” he said. “Give it to the SEC, give it to the stock exchange, or the local baseball team. The issuer still pays, but if they don’t control the hiring, the rating agency has no reason to lie.”
Some have questioned whether this would actually work, because it would lead to a collection of lazy raters:
If you do this, the ratings agencies no longer have any incentives to do much of anything. There are three of them, and presumably each one would get a third of the business at a price set by the SEC. So their incentive would be to hire the cheapest possible analysts and cut costs to the bone. The result would be ratings agencies even less able to cope with complex modern securities than the current ones.
This is what stonkers me about the ratings dilemma: there just doesn’t seem to be any good answer. Turning the ratings agencies into regulated utilities might be better than the current situation, but not by much. And if you’re going to do that, why bother with ratings agencies at all? Why not just have the SEC provide ratings?
Ezra Klein reacted favorably to the problem of effectively nationalizing the rating agency process, what amounts to a “public option.” Dean Baker thinks that the system could be designed to encourage accuracy and provide incentives, with more hiring, for doing so.
The point is that everybody’s just spitballing this, but we’re nearing the end, not the beginning, of Wall Street reform. Twice in the Goldman Sachs hearing, Senators – John Ensign and Mark Pryor – asked those testifying what should be done about the rating agencies, and both times, the Goldman Sachs employees answered that they had no idea. Pryor alluded to some bill he had that would reform the rating agencies, but gave no indication what was in it. And Merkley clearly suggested that the spade work has not been done on this at all. The mini-debate in the blogosphere practically equals the amount of thought but into this at the legislative level, apparently.
That’s incredible to me. As Baker said, “This one is painfully simple for anyone who gives us a damn, but unfortunately that seems to exclude almost anyone in a policymaking position in washington.” Whether you think the problem is more knotty than that or not, you probably can admit there’s a problem. And yet, nobody had much of a sense of urgency to do anything about it, until basically the past few weeks.