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Let’s Eliminate Ratings Agencies


Standard & Poors downgrade of the US has generated much discussion, with some blasting S&P such as Robert Reich and some defending S&P such as Henry Blodget. Whatever you may think about the downgrade, I have a different proposal: let’s eliminate ratings agencies.  By that I mean specifically a government sanctioned oligopoly on rating debt.

Ratings agencies as they exist today are a distinct leftover from a pre-Internet era. They act as aggregators and evaluators of information which in the past was hard to gather and disseminate.  In an age when the information about future cash flows had to be carted around in large paper boxes or more recently via sneaker net, it made sense to have the government put in business some agencies that would receive this information, evaluate it and then condense it into an easily published rating.

With the Internet at hand this makes absolutely no sense.  We can simply require the issuers to publish enough information so that a large number of third parties can evaluate the underlying credit.  This is a radically different approach to regulation, which I have called “forced transparency.” All that government needs to do is (a) set forth what information must be disclosed and (b) require that it be disclosed in machine readable form (the latter is not to be interpreted as coming up with some kind of standard, simply saying that you can’t put your info out there as a bitmap scan of a handwritten document).

Let’s go back for a moment in time to the utter failure of ratings agencies in evaluating mortgage backed securities.  If anyone wanting to issue one of these had simply been required to put up CSV file with the zip code, $ amount of the mortgage, interest rate, value of home and amount of down payment for each underlying mortgage, I am 100% confident there would have been many more alarm bells going off and much sooner.

For various levels of government the data would be different.  For instance, municipalities might have to disclose 10 years worth of population, taxes received by category, expenditures broken down by category and 5-year plans for the same.  And so on.  You get the idea.

Who would do the rating in such a world?  No one in particular and everyone. There would be tons of analysis coming out including hobbyists, graduate students in business and economics, new independent ratings startups and so on.  How would bonds trade without ratings?  Just like equities which don’t have a single rating either but instead a large number of them and trade just fine.

If ever there was a great opening for sweeping reform of a set of institutions that has outlived their usefulness and can be replaced by the Internet, S&P’s action on Friday would seem to be the one.

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