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Who Watches the Credit-Rating Agencies

By Matthew Yglesias on March 14, 2009 at 10:28 am

"Who Watches the Credit-Rating Agencies"

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Felix Salmon has a pretty interesting post about Berkshire Hathaway losing its AAA debt rating. This reminded me that the rating of one’s bonds by the bond-rating agencies is still really important. And also that the rating is done by the same people who were doing the rating two years ago. And that, I think, is a fairly huge problem.

One of the bolder libertarian contentions out there is that the world could do without the function that’s performed by the Consumer Products Safety Commission. After all, the logic goes, consumers want to buy safe goods. This means that producers want to be able to credibly signal the safety of their goods. That means that there ought to be, in a CPSC-free world, a market opportunity for a firms that rate the safety of consumer products. Toaster makers would hire toaster-inspectors, and ask them to give the toasters a clean bill of health. “That’s crazy,” you might say, “who would trust a toaster-rater who was getting paid by the toaster-makers?” But the answer is clear. A toaster-rating agency needs to have a strong, credible brand to be valuable to toaster-makers. Getting a seal of approval from a toaster-rating agency that’s known to cook the books in exchange for business would be worthless. So toaster-raters should stay honest, and those who aren’t honest should find themselves out of business.

Now as it happens, we don’t handle consumer product safety like that. But we do handle bond rating that way. But there are only three ratings agencies. And as it happens, during the late boom years all three acted corruptly. So instead of losing credibility and going out of business, all three are still in business. And when you think about it, something similar happened with the big accounting firms during the Enron bust.

It seems like a big problem to me. Perhaps part of the answer is a Financial Products Safety Commission as proposed by Dick Durbin (co-sponsored by Ted Kennedy and Chuck Schumer, borrowing an idea from Elizabeth Warren). But honestly, I like the free market approach here. I like the idea of a marketplace with multiple raters rather than a single regulatory agency—just think what kind of nonsense a Bush-era FPSC would have green lighted. Not that an FPSC is a bad idea, but I think it’s smart to have a rich, multifaceted approach to assessing these things. Except the market approach seems to have totally failed. Not just failed once in that the ratings-agencies screwed up. But failed in a fundamental way—the agencies’ screwups aren’t doing them any harm, and aren’t allowing any new firms to enter into that space. I don’t know the territory well enough to know in detail what’s gone wrong, but it’s obvious that something‘s gone wrong. And it seems to have something to do with the fact that there are such a small number of players in both the ratings and accounting games.

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