Rating Agency Issues

Can the ratings agencies be saved?

Blind Justice. Photo: Itojyuku Themis. Source: Wikipedia

Investors, companies, and regulators all benefit from having a cheap and easy way to measure credit risk. There are all kinds of institutions with a public mission that need to invest in bonds, and they need their bonds to be low-risk. Investment-grade or A-level credit ratings provide this. But the credit agencies are paid by the bond issuers—a clear conflict of interest. Can this be solved?

This conflict has been with us a long time. It became significant when the agencies succumbed to the collective insanity from 2004 to 2007—some bonds were rated ultra-safe that never should have been issued. Banks, pension funds, towns, and insurance companies all suffered losses.

This issue—the agency issue—is the same problem that accountants, newspapers, psychologists, and just about all professionals have. It’s hard for people to criticize someone if that person is paying them. The professional would be acting against his own interest; the people paying don’t usually like to be criticized.

Take auditors. In the light of Enron, we were shocked, shocked that their accountants helped conceal Enron’s fraud. But Enron was a plum assignment, yielding millions in consulting contracts. The partners at Arthur Anderson were getting rich. Or newspapers: has a critical story ever been spiked because the subject of the criticism buys a lot of ads? Of course it has. The writer Upton Sinclair used to say that it’s difficult to get someone to understand something when their salary depends on not understanding it.

Principal-Agent Problem. Source: Wikipedia

There has never been “golden age” where independent professionals completely subjugated their personal interests for the greater good. Everyone is conflicted in one way or another. The solution lies not in greater regulation but in more competition and more transparency. When a competitor stands to benefit if you fib on behalf of a client, you tend to be more careful.

Professional agencies need to take the agency problem seriously. But everyone’s an agent. We need to admit this and disclose our conflicts.

Douglas R. Tengdin, CFA

Chief Investment Officer

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