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Stop Mandating Reliance on Ratings

By Lawrence White, Robert Kavesh Professorship in Economics & Deputy Chair of Economics

Lawrence White testifies on paperless ticketing

The alternative is continued regulation of the raters, which would make the Big Three raters even more important. Why would anybody want that?

The Justice Department’s suit against Standard & Poor’s is a fresh reminder of the large mistakes by the three major rating agencies – S.&P., Moody’s, and Fitch – in their evaluations of mortgage-based bonds during 2004-2007.

There’s an understandable urge to further regulate bond raters to prevent such mistakes in the future.

But, such regulation is likely to discourage smaller rating firms, who could well be sources of new ideas, methodologies and, technologies.

Some have called for an end to the "issuer-pays" model, where whoever is issuing the bond pays for its rating. But ratings of corporate, municipal, and sovereign government bonds have had the "issuer-pays" model for over 40 years and have not experienced anything like the severe problems that arose in mortgage bonds.

Instead, there is a better way. Eliminate the government’s regulatory reliance on ratings. Since the 1930s, financial regulators have required many financial institutions to heed the ratings of a handful of raters. The goals of the regulators were good: making sure those institutions’ portfolios held safe bonds. But mandating reliance on the Big Three enhanced their importance and made it harder for other rating firms to compete with them.

Read full article as published in The New York Times.