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There has been a long discussion of late about the best way to regulate rating agencies such as Standard & Poors and Moody’s (NYSE:MCO). Recently the Canadian business news channel, Business News Network (BNN), asked viewers to offer their views on the topic. The question compelled me to propose the “claw back” option. It is possible that such a model has been proposed or studied by the industry, but assuming the model is new my proposal was as follows:

The best way to improve the reliability of agency ratings is to introduce “claw back” measures, where the rating agencies are obliged to forfeit the fees they earned to rate a bond in case the bond significantly underperforms its rated category. The forfeited fees could then go toward a fund to compensate the bond purchasers.

This system would have three advantages:

It would hold rating agencies more accountable since they would have some “skin” in the game throughout the life of the bond.

It would lower borrowing costs, since it would increase the credibility of the ratings, as well as offer partial compensations to investors through fee reimbursements and thus act as supplementary insurance. The decline in borrowing costs could compensate a possible rise in rating fees after the introduction of such a system.

It would change the current relationship between the corporate issuers and the rating agencies from a comfortable partnership of sorts to an adversarial one, as rating agencies would assume some of the risk of the bonds (through fee reimbursements) and thus they would be closer to the position of a bond investor, while being paid by the issuer.

It is important to note that forfeiting the fees will not be an automatic process, the fees will only be refunded if the underlying assets significantly and quickly underperforms its rated category, similar to the fast degradation of the triple AAA rated CDOs. However, if a bond is downgraded due to a material degradation in the underlying asset due to natural adverse economic conditions and the degradation is well within the scope of the awarded rating, a rating agency will not be liable to forfeit the rating fees.

Of course, no system is bullet proof. I am sure the industry would resist such a model. While some observers may focus on the difficulty of differentiating between real adverse economic conditions and a premature deterioration in a given bond performance, I believe a determined effort to clarify those issues before such a system is instigated would substantially diminish future conflicts.

Disclosure: No Positions

Source: Regulating the Rating Agencies