How to Improve the Credit Rating Agency Sector

WASHINGTON, JUNE 26, 2008--In the wake of the recent financial bust and subsequent liquidity crisis, critics have lambasted credit rating agencies for the role they played in inflating the mortgage bubble. Many observers argue that the current rating agency model is broken. The Securities and Exchange Commission (SEC), which oversees rating agencies, recently proposed a rule to "address concerns about the integrity of [agencies'] credit rating procedures and methodologies." Industry experts convened at AEI on June 24 to explore the problems of the current system and to debate various proposals for reform in a conference organized by resident fellow Alex J. Pollock.

Erik Sirri of the SEC clarified the agency's position and perspective. He explained that one of the primary problems with the rating agency system is that competition has not forced credit ratings to improve on their own. In a competitive market, the highest quality credit ratings--that is, the most accurate ratings--should gain market share. However, "in an issuer-paid model, people do not purchase credit ratings according to their quality. They purchase them with an eye toward their commercial interests: selling and distributing their products. . . . There is a tendency for the issuer to buy the [highest] credit rating," not the most accurate one. Consequently, Sirri explained, the goal of the SEC is to identify and support a mechanism that will allow "normal competitive forces" to operate in the ratings market.

Lawrence White of New York University disagreed with the SEC's proposed rules. He said that further regulation "is likely to make things worse. It is a big mistake." White proposed that the SEC no longer require that rating agencies gain the SEC's approval and that other regulators no longer mandate the use of ratings from approved agencies--practices that he argues have severely restricted competition. Because certain rating agencies are cited in regulations, White added, regulators are tacitly endorsing their bond ratings and are effectively "outsourcing safety and soundness decisions" to this small group of firms. If regulators stop forcing investors "to pay attention to a select group of credit raters," White believes that "the market . . . [actors will] to make up their own minds" about how and by whom bonds should be rated.

Joshua Rosner of Graham Fisher & Co. agreed with White's conceptual goal of "eliminating the need for rating agencies as outsourced gatekeepers." Ideally, he would want the system to be restructured so that "no one is required to rely on rating agencies." But, in the meantime, he argued, more regulation is needed. Sylvain Raynes of R&R Consulting countered that having dominant rating agencies is necessary. He asserted that in the buyer-seller model, conflicts of interest are inevitable, which is why "we need ratings. We need a third party which is objective."

Sean Egan of Egan-Jones Rating Co., a firm which is 100 percent paid for by investors and whose only clients are institutional investors, said that "you want a truly neutral third party so it can do some due diligence." He also commented that the SEC proposal "proceeds from an erroneous premise that the major rating agencies are in the business of issuing timely, accurate ratings." In reality, "they are in the business of facilitating the issuance of securities. . . . When they tightened up their standards, they lost market share." Egan suggested that the SEC's proposed rules need to be revised significantly; otherwise, "the credit markets are likely to remain impaired and vulnerable to serial breakdowns."

--KAREN DUBAS

For video, audio, and more information about this event, visit www.aei.org/event1745/.

Alex J. Pollock has written extensively about rating agencies, including government testimony on the subject. He also moderated a November 2007 conference on problems in the rating agency system.

For media inquiries, contact Veronique Rodman at 202.862.4870 or vrodman@aei.org.

###