Seeking Alpha
Profile| Send Message| ()  

All the complaining about the downgrade of America's debt rating by Standard & Poor's is a good time for a reminder that in many important ways these ratings agencies are (or at least were) creatures of the government. The Wall Street Journal had two articles yesterday bearing on the point, one referring to "a provision in last year's Dodd-Frank financial overhaul that requires U.S. financial regulators to purge references to ratings from their rules" and a second referring to that more conditionally:

Dodd-Frank also requires U.S. regulators to purge references to ratings by one of the 10 SEC-approved firms from their rules. If approved, the move might encourage bond issuers to seek ratings from smaller firms and prod investors to pay more attention to them." The second article also reports, "Pension plans, mutual funds and other large investors often have mandates to buy securities with ratings from one or more of the 10 firms registered with the SEC.

The SEC website has a mind-numbingly long list of links to rules, laws, reports, compliance guides, and orders related to the issue of what it calls Nationally Recognized Statistical Rating Organizations. To qualify as an NRSO, an organization has to fill out "Form NRSO," which, with instructions, is a 25-page form that the government estimates the "average burden hours per response" is 400. So if you think you can do a better job than the S&P at assessing the risks of U.S. government debt, good luck spending those 400 hours filling out that form.

But it's not just the SEC that has mandated reliance on these rating agencies. New York state's laws regulating insurance companies, for example, state:

A financial guaranty insurance corporation's investments in any one entity insured by that corporation shall not exceed four percent of its admitted assets at last year-end, except that this limit shall not apply to investments payable or guaranteed by a United States governmental unit or New York state if such investments payable or guaranteed by the United States governmental unit or New York state shall be rated in one of the top two generic lettered rating classifications by a securities rating agency acceptable to the superintendent.

And New York state's laws governing retirement funds require that "each such obligation at the time of investment shall be rated investment grade by two nationally recognized rating services or by one nationally recognized rating service in the event only one such service rates such obligation."

None of this is to say that ratings agencies might not play a valuable role in assessing securities; they might, just as restaurant reviewers play a valuable role in assessing restaurants and movie reviewers play a valuable role in assessing movies. But the government doesn't license restaurant reviewers or movie reviewers. Consumers can choose on their own to pay attention to the ones, if any, that they think are useful and disregard the ones they think aren't. The highly regulated approach to securities rating agencies failed when it came to detecting bad mortgage-backed securities, and it doesn't seem to be much more useful in assessing government bonds. The faster that not only the federal government but also state and local governments and the pension funds they control move to dethrone these rating agencies from their exalted semi-official status, the better off we'll be.

Source: Regulating the Raters