Should Credit Rating Agencies Be Compensated for Their Assessment Services?

Credit rating agencies serve an important role in financial markets; they take a complex

analytical process and an equally complex output, namely the probability or likelihood of default

of a particular debt instrument or structured debt instrument under varying economic

circumstances, and convey it to the public in an easily understandable way (i.e. via letter

“grades”). Given that the probability of default of a debt instrument determines in large part its

demand, liquidity, and price, providing an assessment of this default probability is of significant

value. As such I have no problem with credit rating agencies being compensated for the sale of

their assessment services by the debt underwriter/arranger that hires them to provide this

assessment. Are there conflicts of interest under this setup? Absolutely—but that is the

responsibility of the individual investor to assess.

In my opinion, it is up to the individual investor to have a fundamental understanding of

how these credit rating agencies operate and how they generate revenues. While the intricacies of

their operations are a bit esoteric, I don’t believe that it’s beyond the realm of what’s expected of

an individual who plans to invest their money in the market. In effect, I agree with the argument

put forth by some courts that maintain that credit rating agencies are members of the media and

that their ratings are opinion and are therefore protected under the First Amendment.

Turning to the most recent financial crisis, I believe that it was a matter of

overconfidence and overreliance by the public in the soundness of the credit rating agencies’

AAA ratings of debt instruments that ultimately turned out to be junk (arguably below junk). I

believe that credit rating agencies only have as much power as the public lends them. Ultimately,

sufficient individual research and analysis, either by oneself or by a hired professional, is

required.

Increasing the amount of regulation will only promote more overconfidence and more

overreliance by the public on the soundness of ratings. Inevitably, this overconfidence and

overreliance will lead to the same type of herd mentality we saw during the financial crisis.

When the rating agencies get it wrong, as they surely will, (after all, not even credit rating

agencies can be right 100% of the time) we will likely see yet another financial crisis. Passing

laws that attempt to align compensation structures that promote objectivity among credit rating

agencies sounds like a great idea, but so does every other form of regulation that’s been passed,

allegedly in the best interest of the public; and guess what? Financial crises still occur. Why?

Because the market is the best regulator. If the law didn’t require, and therefore prop up, the

existence of these credit rating agencies, then the agencies that get it wrong will be cleared from

the market place. Those that get it right will remain.