Lawrence White Op-Ed: Stop Mandating Reliance on Ratings

The following is an Op-Ed written by Lawrence White, NYU Stern Professor of Economics published online on the New York Times Opinion Pages.

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. But, such regulation is likely to discourage smaller rating firms, who could well be sources of new ideas, methodologies and, technologies.

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.

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.

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 Dodd-Frank Act of 2010 instructed federal regulators to eliminate their mandated reliance on ratings, and some bank regulators have done so. But, maddeningly, for money market funds and broker-dealers, the Securities and Exchange Commission continues to mandate reliance on ratings.

Faster S.E.C. action would give smaller rating firms more opportunities sooner.

The alternative is continued regulation of the raters, which would make the Big Three raters even more important. Why would anybody want that?

Read the original post here.

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