Delphi Financial’s Robert Rosenkranz gets it exactly right in Friday's Wall Street Journal: “Let's Write the Rating Agencies Out of Our Law.” I’m trying to find much to disagree with, and am having trouble. This part is especially good:
Rating agencies employ quite ordinary mortals to analyze the credit risk of bonds, just as firms like Goldman Sachs and Merrill Lynch employ quite ordinary mortals to analyze the outlook for stocks. No one is shocked when equity analysts' recommendations don't pan out. Why should we expect any more of the rating agencies?
We should not, but the regulators have, and that is the problem. Regulators of banks, insurance companies and broker dealers have all incorporated the work of the ratings agencies into their regulations in myriad ways. Most importantly, bond ratings determine - as a matter of law -- how much capital regulated institutions need in order to own the bonds. . . .
Since the ratings determine required capital, they have a profound influence on how financial institutions invest their assets -- in effect, the regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating. [Emph. added]
If anything, Rosenkranz goes too easy on the agencies. He fails to point out, for instance, the havoc their recent arbitrary, capricious, ass-covering downgrades have wreaked on the financial system. But he’s correct to argue that the much-needed overhaul of the industry’s regulatory structure should entirely exclude any reference to the agencies and their actions. I’d go one step further: terms and covenants in lending agreements between private parties that depend on an issuer’s credit rating (or make any reference to credit ratings at all, for that matter) should be deemed unenforceable. The grip of rating agencies on capital allocation decisions needs to stop.
Ironic, isn’t it, that regulators insist financial institutions rely on the markets to value their financial assets, yet ignore those same markets in determining capital requirements for financial institutions? I have my own doubts about the wisdom of the judgments the markets seem to be dispensing these days. But the wisdom of the work coming out of the rating agencies lately has been even shakier.
The sooner the agencies lose their quasi-official status in the financial markets, the better. Rosenkranz gets the ball rolling nicely in starting the debate.