AAA Dilemma: What if the Ratings Agencies Disappeared?

In general, there’s a conflict with the ratings agencies because they are a bit of a proxy regulator, given power through the federal government to rate bonds and other financial instruments, and so many other bodies can’t invest their money in a financial instrument unless it has a certain rating from certain ratings agencies. Moody’s, S&P, and to a lesser extent Fitch have a stranglehold on the system because they’re written into law and there are high barriers to entry to starting a new rating agency. Anyways, there is the conflict because they exist in a market, but the companies that they rate pay them. 

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So there is this question about how independent the ratings are, since if they don’t get the rating, they like from one agency, they can just walk down the street to another. And then there is the prestige issue, where the people packaging financial instruments have more power because they work at Goldman and make multiples of what someone at a ratings agency does. Overall, I think this relationship had a big effect in the run up to the financial crisis because the CDOs were being rated AAA for even their riskiest tranches because there was a fundamental lack of underwriting going on and the ratings agencies were not ready to push back against these banks to say that you’re selling people trash that will blow up. Of course being real close to the day to day activity, you really don’t have the perspective to say that this will be one of the things that makes the whole house of cards fall down, but at least you can say that the credit on these mortgages is too bad, and you’re not taking in account correlation risks, and there is a chance that house prices may go down. The riskiest 5% of these are not as good as treasuries.

Thinking if the ratings agencies went away for some reason, the first thought is to say good riddance. But the second thought is that there is a lack of information in the marketplace by not having these quasi-independent bodies, overall it would drive up costs in the market and make borrowing more expensive for everyone. What it would more likely would do is make a mirror of the equity market. The larger companies would get independent research done, so Disney and US Steel could issue bonds, but for smaller and less liquid offerings, that is where costs would go up the most – bifurcation the market so that the rich got richer. Hopefully the state would step in to offer truly independent ratings until that agency got captured.