The Missing Link in Financial Reform

Paul Krugman of the NY Times weighed in yesterday on the need for more meaningful reform of ratings agencies.  This is an area of regulatory reform which has fallen by the wayside, to the detriment of the future stability of the financial system.  The case against the current setup for ratings agencies is quite simple.  Currently, the issuers of debt pay the ratings agencies for their services, and issuers have a choice of which ratings agencies, resulting in agencies having the incentive to 'inflate' the ratings to some extent - as issuers will naturally pay the agency most likely to provide them with the highest rating. 

In the run-up to the crisis, investment banks would shop their structured products to a variety of ratings agencies and pay whichever firm was willing to rubber stamp said products with the highest ratings.  A number of emails have recently made news for highlighting the misconduct at the ratings agencies which resulted from the pressure to give the ratings that the bankers were seeking.  Large scale investors which were either too lazy or lacked the institutional capacity to do their own homework on such structured securities relied heavily on rating agencies to do their due diligence for them, leading to catastrophic losses when the securities experienced heavy losses.  Evidence of the distortions created by these incentives is offered by the fact that over an 18-month period of the crisis, Moody's and S&P downgraded more securities than they had in their respective 90 years of preceding history.  When these securities were downgraded, institutional investors with investment profiles which included minimum ratings thresholds (Ie. most pension plans are only allowed to invest in AAA securities) were forced to sell their securities  into suddenly illiquid markets, thereby compounding their losses, as well as those of others who were marking their assets to market (until the FASB suspended such practices).

Krugman is not convinced that the proposed reforms do not effectively deal with the skewed incentives of ratings agencies it appears that he is right.  Krugman supports the proposition that issuers continue to pay the ratings agencies, but a third party, such as the SEC chooses which agency rates which debt.  This seems reasonable, although I am skeptical of the SEC's ability to fight their way out of a wet paper bag, let alone invent a reasonable process for assigning rating responsibilities.  A similar structure with a more competent 'middle man' strikes me as a reasonable solution to one of the most overlooked shortcomings of our current system.