Jamal Mecklai: Of ratings and regulators

MARKET MANIAC

The fact that the knives are (finally) out for the rating agencies is, perhaps, a signal that the worst of the sub-prime crisis is behind us. If this is true, that would be great for markets, but it is way more than high time that the conflicted business model of the rating agencies was overhauled for good.

The agencies themselves are in active redesign mode, but there appears to be very little discussion of the fundamental conflict of interest issue, which goes as follows: If I pay you to rate my paper, you (whatever your morals or credentials) are my man. I own you. S/he who pays the piper calls the tune.

Which makes it amazing "" indeed, ludicrous "" that investors depend on ratings paid for by issuers to take investment decisions. Now, investors are, in general, not fools. None of them, for instance, would buy a house or a car or whatever based on the certification provided solely by the seller. Why then did they "" indeed, do they "" continue to put their money into investments that are certified by someone paid by the seller?

The simple reason is that ratings have become an unquestioned part of the financial landscape because they have been given the hallowed shine of authenticity by financial market regulators. For decades, central banks have required banks to allocate risk capital to investments based on their credit ratings, effectively building up the completely false perception that these ratings "" which, the raters themselves call "merely opinions, which should not be relied upon to make investment decisions" "" are accurate measures of risk.

Now, my intention is not to vilify anybody "" just to point out that it is foolish to have the underpinnings of a system based on a business model with no accountability. While losses to investors in the sub-prime mess have exceeded $100 bn, the agencies based on whose ratings most of these investments were made suffered zero financial loss. ZERO FINANCIAL LOSS. That doesn't make sense. If I make a mistake in my business, I (usually) have to pay for it "" with money, not just supposed reputation loss.

So, while the game of trying to come up with an acceptable via media has already started, my belief is that no meaningful via media exists.

First of all, we need to recognise that ratings are the grease that makes financial markets turn, and they are responsible in no little part for the huge increase in liquidity globally and, as a result, the low cost of capital. Thus, we need some form of ratings. However, ratings should have two properties:

1) the companies who sell them should be accountable "" that means if I, as an investor, rely on them and they go wrong, the rating company should be responsible to share in my loss, and

2) they should be paid for by investors, which is both obvious and a natural corollary to (1) above.

Clearly, this would mean that rating companies would have to be quite different structurally "" first off, they would need to have substantial capital, which means that the cost of ratings would go up. Which means that the cost of capital would rise "" or, perhaps I should say, rise to the correct level. If the actuarially calculated cost of providing for the recent $100 bn of losses had been built into the cost of capital, I dare say we wouldn't have had the kind of crisis we are currently reeling from.

Now, don't get me wrong "" I have nothing against crises. Indeed, I think they are necessary to flush excesses that build up in any free market system. However, the game needs to start with clarity and accountability "" the prices must be right on Day 1.

Secondly, there would have to be some mechanism to ensure that users of the ratings pay for them, rather than, as currently, having ratings paid for by the rated company "" incidentally, this same conflicted model continues to hold in the case of statutory audits.

While distributing ratings and collecting fees from a wide array of investors can pose a challenge, the problem is no reason to settle for a structurally flawed model. One idea could be to have stock exchanges pay for ratings and recover the cost from a charge on trading fees. This would certainly be technologically feasible, would address the current conflict of interest, and could, indeed, lead to a new business opportunity for financial exchanges. Another idea would be to have institutional investors allocate their rating charges to different ratings providers "" presumably they would distribute their fees in the ratio of the value they received from different agencies.

Now, while all this may sound complicated and would certainly take a lot of work to implement, particularly given the vested interests of the existing players, not doing something just because it is difficult is hardly a justification.

Incidentally, a lot of what I have written here is a replay of an article I wrote when Enron went under. At that time, the audit profession got shaken up. I guess it's taken a much larger set of losses to focus regulator attention on the bigger problem.