The Bond Raters Still Need to Be Fixed
Barry Ritholtz has written this article in the context of the US Financial Services industry but he might as well be talking about India given that India’s rating agencies have covered themselves with as much muck over the past four years as the US rating agencies did in the run-up to the Lehman crisis. For those of us who lived through the Lehman crisis, the sins of the rating agencies are a story we have heard before: “Moody’s and S&P (Fitch was a relatively small player) slapped investment grade ratings on securities backed by junk subprime loans because they were literally paid to do so by debt issuers. Issuers shopped for ratings — if Moody’s refused to provide a desired grade, then S&P would (and vice versa). When it all went south, the debt raters made feeble attempts to claim their ratings were “opinions,” or protected political speech under the First Amendment. These arguments failed, eventually leading to fines for their malfeasance. S&P paid $1.5 billion to settle with the U.S. and individual states; Moody’s paid a much smaller fine.”
So what can be done to fix the rating agencies especially since 11 years on from Lehman the agencies seem to be riddled with the same conflicts of interest that destroyed the fabric of the financial system 11 years ago? Ritholtz has a few suggestions that regulators should consider:
1. Sell ratings to bond buyers, not bond issuers: “…During the 19th century, investors in railroads paid for information on the quality of the bonds they were buying, which is how S&P and Moody’s got their start. In the 1970s, the raters began the practice of charging issuers for their services, displacing the subscriber-pays model. That the investor-pays model once prevailed suggests that under the right conditions and with the right incentives it could work again.”
2. Assign and rotate rating companies randomly: “After the many accounting scandal of the early 2000s…a number of reforms were made to the accounting industry. Included in the Sarbanes-Oxley Act was the establishment of the Public Company Accounting Oversight Board, or PCAOB. This established new standards for independence, created audit rules and mandated quality control. Perhaps most importantly, it required whoever the lead partner was on an audit to rotate off that project every five years, reducing the tendency of those who are supposed to work at arm’s length from getting too cozy….The incentive to cheat was replaced with a high probability of getting caught. The result has been a dearth of the kind of accounting frauds that were so common in the late 1990s and 2000s.”
3. Eliminate the government stamp of approval: “The credit raters were granted special government dispensations in 1975, setting them up as the official arbiters of corporate credit quality. This unique status created a moral hazard, with raters facing few consequences for their actions; it is also what enabled the structural problem in the first place. Compare this situation to the equity side: the dot-com implosion taught stock buyers not to rely on Wall Street analyst ratings, which exist (mostly) for the benefit of investment bankers, not investors.”
Ironically, although India has made more progress than America in bringing the auditors to heel (through mandatory rotation of auditors and through the creation of an independent regulator for the audit profession), India has done as little as America to make the credit rating agencies more accountable. Ritholtz’s ideas therefore have as much relevance in India as in the US.