The rating agencies insist that they merely issue opinions that one can take or leave, a position that is absurd given the fact that laws and regulations force institutional investors and banks to rely on ratings to make investment decisions. After the financial crisis, when many people would have been happy to never use the big three firms again, bond issuers still had to pay them for ratings because most institutional investors must own rated securities. By law, investors and banks still used ratings to determine what bonds they could and could not hold.
Stripping references to rating agencies out of regulation (which has been proposed by the SEC and the Dodd-Frank reform bill) has been stymied by bank regulators like the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency (OCC), according to Professor White, because they do not want to have to take on the responsibility of deciding whether investments held by banks are safe. “It is much easier for regulators to outsource the job of deciding what is safe for banks to own to the rating agencies,” he says.
Don’t get me wrong, I understand why there has been a reaction to S&P’s move but I remain incredulous that we have collectively built a system that makes any pronouncement from them of material interest to our financial system and economy. This is even more true with respect to sovereign debt issuers.
Whether or not rating agencies exist should be moot with respect to the workings of the financial system: people can and should do their own due diligence. If they choose to outsource this to S&P or any other body, good luck to them (and to S&P) but it is insane that this small oligopoly of public companies can extort rents and wreak havoc due to their legal and regulatory entrenchment in our financial system. And even better (for the NRSOs), without taking any responsibility for their “opinions”.
Sure without ratings, some things might be harder for regulators, banks, debt investors & issuers, and the world might “look” messier, but it wouldn’t actually “be” any messier. And forced to acknowledge and deal with this complexity (rather than arbitrage it), the financial system would be significantly more robust for it.
And this would give the upper hand to asset “managers” as opposed to asset “gatherers” which has to be a good thing in my book.
The faster we can remove any official, regulatory or legal foundation for the use of credit ratings the better. Alas, it seems that the establishment prefers the false certainty of our broken system, to the messy truth of a robust one. I’m not holding my breath, although the universally acknowledged sentiment that the S&P US downgrade provides “no new information” (irrespective of how people feel as to it’s logic/justifiability) and the (understandable) hysteria it engendered might get the debate moving in this direction after all.
Coda: It is no surprise to me that the class of debt investors (hedge funds) that vastly outperformed the others (banks, mutual funds, insurers) over the last few years are the investors who relied least on credit ratings and almost never had ratings structurally built into their investing criterea.)