One proposal for improving the rating agencies

…Levy and Peart propose a simple solution: randomization. 
Rotate ratings firms the way that baseball rotates umpires. 
If they were assigned by lottery, rating agencies would have enhanced incentives to take the public interest into account — and diminished incentives to try to please underwriting institutions that were paying the bills.  Something of the sort was incorporated among the reforms mandated for accounting firms by the Sarbanes-Oxley Act of 2002 — the rotation every five years of the lead audit partner and the reviewing audit partner was required, for example, and more frequent changes of firms themselves was recommended. But the measures stopped well short of randomization.

Here is the full discussion.  Yes that Levy is my colleague David Levy, who has been a major influence on our department, most of all through his book The Economic Ideas of Ordinary People.


"Levy ... a major influence on our department, most of all through his book The Economic Ideas of Ordinary People."

I'd be interested in hearing how the book has influenced the department. The book's topic has always interested me, but I've never been able to quite understand Levy's approach.

The absolute number one thing to do to improve the credit rating agencies is not force the markets having to follow their criteria in any way or form. Anything else is silly and will only help to set us up for worse crisis.

The end of the day fact is that the better the credit rating agencies are at what they are doing the larger the risk that trusting them we will be introduced to a systemic risk of catastrophic proportions. Already today one can almost find more financial courses teaching how to interpret what the credit rating agency might say of a company, and how they could change their minds abut that company, than courses that teach you how to analyze that same company.

Today FT reports on “IMF warns of risks to global growth† that John Lipsky, the number two official at the International Monetary Fund, seemingly quite unseemly washing his hands in relation to the issue whether the credit rating agencies have done their job well said “The basic issue is that in the end, professional investors bear ultimate responsibility for risk assessment and management in a securitized market. It is not realistic to expect third parties to take that responsibility.†

There is of course nothing to object to that statement, c´est la vie, but it clearly leaves a question or two about what to do with all those who are not professional investors or that just thought they were and who followed the advice of the credit rating agencies just as the bank regulatory authorities, and the IMF, told them to do. Is the IMF now arguing for two bail out systems now? One booth for the professionals and one for the credit rating agency followers?

I thought people here favored a "free market" so why impose this regulation?

If ratings agencies are biased or on the take than isn't the market suppose to punish them?

Something seems inconsistent to me...

Why not pay the rating agencies with something similar to a mezzanine PO strip? The problems come from the people assigning a fair division of risk are paid from the initial principle transfer, so their only risk is that they do such a bad job that they won't destroy their reputation. Once they've split the fund give them the equivalent of the present value of their upfront fee in first loss principle payments so they have a huge incentive to get the ratings right (too conservative and the first losses will sell at a higher value so their fees are smaller).

It works quite well with two year olds, so it seems like it would still work with math majors (ie the divider gets the last piece taken).

The existing system is not broken. Experienced analysts knew that AAA ratings for exotic CDO and ABS tranches were not worth their rating. Only fools buy what they can't understand, listening to an expert telling them that it is safe, or it will provide them with a high income.

David Merkel

Re David Merkel: “Only fools buy what they can't understand, listening to an expert telling them that it is safe†.

No, many have also been ordered to listen to what those experts appointed by the regulators, the credit rating agencies, tell them.

Re Patinator: The only thing the rating agencies were slow to do was downgrade the bonds.

No, the first problem was that they were to fast AAA rating bonds backed up by mortgages that no one had gone out on the street to see how they were awarded.

Re Patinator “the 20% loss coverage changes with how the rating agencies view the likelihood of the collateral defaulting (less likely for prime, more likely for subprime).†

Yes and these likelihoods they got out from past data without “walking the streets to see for themselves how the new mortgages were awarded† by which they would have discovered that these were much worse than historical subprime.

Re Patinator asks “Can you give me some examples here so I can get an idea of what you mean?† on my “many have also been ordered to listen to what those experts appointed by the regulators, the credit rating agencies, tell them."

In many ways or forms, explicitly, for instance determining capital reserve requirements and prohibiting some investors like for instance pension fund from investing in paper below a specific grade. Implicitly by signaling to the market that “someone out there is capable of actually being able to measure credit quality scientifically† and which has of course only helped to support the whole notion of being able to diversify away risks, while in fact they only go into hiding.

I have been on this argument about the credit rating agencies for a long time and yesterday August 24 in the Financial Time, Charles Calomiris and Joseph Mason in “We need a better way to judge risks† also mention that there is no “use blaming the rating agencies, which are simply responding to incentives inherent in the regulatory use of ratings† and recommend that we just have to avoid “settings standards for permissible investments by regulated institutions†.

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