Stop Mandating Reliance on Ratings … The Justice Department's suit against Standard & Poor's is a fresh reminder of the large mistakes by the three major rating agencies – S.&P., Moody's, and Fitch – in their evaluations of mortgage-based bonds during 2004-2007. There's an understandable urge to further regulate bond raters to prevent such mistakes in the future … Instead, there is a better way. Eliminate the government's regulatory reliance on ratings. Since the 1930s, financial regulators have required many financial institutions to heed the ratings of a handful of raters. The goals of the regulators were good: making sure those institutions' portfolios held safe bonds. But mandating reliance on the Big Three enhanced their importance and made it harder for other rating firms to compete with them. – New York Times
Dominant Social Theme: The solution is simple … force them to behave!
Free-Market Analysis: The New York Times recently opened up its editorial section to a discussion of why ratings agencies had failed so miserably during the financial crisis of 2007-2008 and what could be done to improve them.
We've written about this in the past, concluding that rating agencies were useless in an era of monopoly fiat (central-banking) money. But Dr. Lawrence J. White makes some good points in his recent editorial.
The professor (not to be confused with free-market economist Lawrence H. White) was part of an editorial panel making recommendations. Several on the panel recommended increased government force to make the ratings system viable once again. Dr. White had a different perspective, based on US regulatory history. Here's more from his editorial suggestion:
Some have called for an end to the "issuer-pays" model, where whoever is issuing the bond pays for its rating. But ratings of corporate, municipal, and sovereign government bonds have had the "issuer-pays" model for over 40 years and have not experienced anything like the severe problems that arose in mortgage bonds.
And since bond markets (except for municipal bonds) are dominated by financial institutions, most bond investors are managers of institutional portfolios who are (or should be) professionals. There's no need to require that these institutions rely on the rating agencies' grades. Professional bond managers can exercise judgment on whether to do the necessary research themselves or, if they rely on third-party advisers (like ratings agencies), decide who is reliable, and be held accountable for their choices.
For some institutions – banks, insurance companies, pension funds, etc. – there still needs to be regulatory oversight of their research or their choices of third-party advisers. But this can be much less constraining than the mandatory use of ratings from a handful of raters.
The alternative is continued regulation of the raters, which would make the Big Three raters even more important. Why would anybody want that?
Good points. But one Dr. White doesn't make (possibly because it is too radical) is that rating agencies are basically useless in an era of monopoly fiat money: It is the propensity of central banks to print money that causes artificial booms and busts that make rating predictions invalid.
Then there is the issue of regulatory discretion. In the 1920s, companies provided financial reports to shareholders on an ad hoc basis. If a company provided financials, it was seen as a signifier of good standing. The company had nothing to hide, else why commission the reports?
But after the Pecora hearings produced a raft of regulatory agencies, it was determined by the fledgling SEC that "public" companies should be mandated to produce such reports.
Regulators, looking at the marketplace, saw that companies producing such reports were held in high repute. But they misunderstood the mechanics of the marketplace. They assumed the report itself was what elevated a company's status and reputation. In fact, it was the DECISION.
And once the SEC took away the ability to make the decision and mandated the production of financials, the entire dynamic changed. Companies that might have been inclined to produce a transparent financial report began to treat the report – along with everyone else – as something to be avoided or "gamed."
This is why regulatory mandates so seldom produce expected results. By mandating the use of the Big Three ratings agencies, US regulatory authorizes effectively monopolized them and made their services less effective and then, in the long run, useless.
There are two lessons here. First, mandating transparency is simply a way to ensure that companies will move in the other direction. Second, when one part of the regulatory procedure is monopolized, other parts won't respond in the anticipated manner.
By initiating and sustaining a system of monopoly fiat, the US Congress has rendered ratings agencies moot. Much of the world's financial system has been propped up by literally trillions in money printing over the past five years; surely it is not possible to provide sensible ratings in an environment where the monetary system itself is collapsing.
For these reasons, even Dr. White's free-market solutions don't go far enough. He wants to free ratings agencies from regulatory statism. But what must be done first is to free money from monopoly central banking.