Buyers should pay for ratings

The following is taken from an opinion column written by New York Insurance Superintendent Eric Dinallo and published in the Wall Street Journal.

There has been a great deal of justified criticism of the role played in the financial crisis by rating agencies who overvalued structured debt products. Lots of people agree that something should be done. But what, asks New York Insurance Superintendent Eric Dinallo?

A recent report by the Group of Thirty—an international monetary affairs think tank—recommended that regulators encourage the development of payment models that ‘permit rating users to hold rating providers accountable’. Similarly, Securities and Exchange Commission head Mary Schapiro recently called for an examination of ‘how the rating agencies are compensated, how they manage conflicts of interest, and what role they should play in our markets.’

The insurance industry and its regulators can lead the way by implementing the only effective proposal: self-funded, independent buy-side ratings. Ratings, that is, that are paid for by the investors who use them.

Rating agencies' failures are not rooted in a lack of talent or insight, but rather in a fundamentally flawed business model. Those who issue the securities also pay for their ratings. This structure has created powerful incentives to bias ratings to keep debt securities' sellers satisfied and the rating fees flowing.

“The solution is for investors to buy and control publicly available bond ratings.

Consider that in 2003, on the equity side, regulators entered into settlements with Wall Street firms to resolve conflict-of-interest issues between their research and investment banking divisions. Like the rating agencies, equity research analysts held themselves out to be objective in their analysis because they were paid by the issuers and their bankers. The regulators' investigations demonstrated that the firms and their client-issuers pressured equity analysts to provide bullish recommendations on their worst stocks.

The solution is for investors to buy and control publicly available bond ratings. Insurance regulators, who use ratings to determine capital reserves for insurance companies, can contract with rating agencies on a competitive basis to provide public ratings of issuers and their securities. This approach would solve the conflict-of-interest problem, because the primary users of the ratings are the ones who will be paying for them.

To fund a buy-side proposal, insurance commissions could collect a small fee from insurance companies that hold nearly $3 trillion in rated bonds, making them the largest industry sector that relies on credit ratings. The New York State Insurance Department estimates that for less than two basis points (0.02%) per year insurers and their regulators can purchase transparent, conflict-free and cost-effective ratings. Buyers have a strong incentive to pay into a system that ensures the independence and accuracy of their ratings.

Ratings will never be flawless—no institution can have perfect foresight. But buy-side ratings will be conflict-free, and the process will be controlled by the investors that bear the long-term risk of the rated securities. Rating agencies with poor track records, errors or conflicts will not be trusted to serve and protect policy holders. And rating agencies will bid for contract renewals based on merit, so that they remain independent of the issuers they evaluate.

The collapse of confidence in ratings paid for by sellers has caused and sustained the disruption in our credit markets. A buy-side system can finally restore integrity to a rating system that has lost the trust of regulators, legislators, markets, purchasers, the press and the public. It is time for a change.