The best solution must address the fundamental problem with ratings: we do not know how good ratings are on average until bonds mature or default. The solution thus must depend on future performance.
An effective solution to the ratings problem would make the profits that rating agencies earn depend on how the bonds they rate perform. Credit agency profits should rise if bonds they rate as investment grade perform well and fall if such bonds default more often than expected.
Credit rating agencies could create this contingent compensation scheme by putting a meaningful portion of their fees into escrow. The custodian of these funds eventually would return them to the agencies if their ratings performed well.
To fund their operations, the rating agencies could borrow against these escrowed funds, using their future contingent payments as collateral. The lenders then would rate the raters instead of the government. The SEC could create this system simply by requiring that rating agencies opt in if they want the NRSRO designation. The SEC would then only need to determine whether the deferred contingent compensation schemes used by each credit agency provided meaningful incentives to produce well-researched and unbiased ratings.
Finally, the SEC should require disclosure of these deferred contingent compensation schemes, so that investors can decide for themselves which schemes provide adequate incentives to rate securities well. The proposal outlined here allows the power, creativity and wisdom of the free market to produce the best solution.
Friday, June 4, 2010
A new idea from Larry Harris (former SEC chief economist) in an article posted in the Financial Times: