Rating the rating agencies
In the 12/1/2008 Barron's, Tom Sullivan writes about the Big Three Rating Agenies — Moody's, Standard & Poor's, and Fitch Ratings. The SEC is reviewing how these agencies are regulated and "the basic business model employed by the largest agencies" is "open to question". What does this mean?
The main issue is who pays and what incentives this model creates. Today, the issuer of debt pays the rating agency to issue the rating. Imagine if you could create your own credit score before applying for a credit card, auto loan, or mortage — or paying a "third party" to rate your credit. What would you do? Shop around and find a rater who will give you a good score. That is exactly what happens with S&P, Moody's, and Fitch. When the issue of the debt pays, they are looking for a good rating. In order to get the business, perhaps the rating agency is not as rigorous in its assessment.
As evidence, Barron's compares debt ratings provided by the Big Three with ratings provided by Egan-Jones. They are a new rating agency where the investor pays. Their ratings are all lower when looking at debt of several financial institutions and insurers.
The other problem with the traditional model is the requirement among some investors (like pension funds pr mutual funds) to only invest in debt with certain high ratings. But what are those ratings really worth, when they underlying business model that created them is flawed?
