Rating agencies were one of the biggest contributors to the Financial Crisis of 2008.  By stamping a 'AAA' grade onto low quality subprime Morgtgage Backed Obligations (MBOs), they turned them into investment grade securities.  Trillions of dollars' worth of these securities were sold around the world, to commercial and investment banks, hedge funds, and pension funds.  Government and financial institutions alike relied on the trusted names behind these ratings - Moody's, Standard & Poor's, and Fitch.  The money from the sale of these bonds often went right back into the housing market, inflating prices further.  But once the housing price bubble finally collapsed and people started defaulting on their mortgage payments in huge numbers, many of the bonds became worthless. The buyers of these products suffered huge losses, threatening the solvency of many financial institutions, and initiating the federal bailout for hundreds of billions of dollars.

The state of Ohio is now suing Moody's for $457 million due to losses in their pension funds, claiming that they relied on the AAA ratings, and alleging fraud and abuse at the agencies.  Other states with similar losses are not far behind.

Investment banks that bundle up the mortgages into securitized MBOs, like Goldman Sachs and Lehman, must pay the ratings agencies for the ratings.  This is a huge conflict of interest.  The ratings agency has the incentive to charge more for a better rating (or for the company selling the bond to pay more) because a highly rated bond will sell much better.  Furthermore, the ratings agencies can charge for consultation services, which show the bond-sellers how to structure or fine tune their offerings for the highest ratings.  And finally, if a bond-seller is not happy with the rating they received, they can shop around to the other ratings agencies for a better deal.

The history of ratings agencies

The big ratings agencies all started as subscriber services.  Moody's for example, started in 1900 by John Moody, published a book of information and statistics on stock and bonds, and it was sold directly to the public.  Circulation increased rapidly, as there was a huge demand for this information by the investing public.  Later, Moody included the established letter grading system into his analysis.  Thus the ratings agencies were directly accountable to the public and competed between themselves for customers based on quality and accuracy.  Although there may have been errors and abuses, the free market held them in check, because investors could easily switch to another provider if they felt that one was not being honest.

However, all this changed in 1970.  After some people were burned in the bond market, the government required that all bonds must be 'investment grade' in order to be sold to the public.  They chartered the big 3 agencies: Moody's, S&P, and Fitch, to provide the ratings that would be used for this purpose.  Thus, bond sellers were required to get a rating from the agencies, and effectively they became a cartel.  They could charge companies directly for access to the credit markets.  And that's exactly what they did.  This was seemingly great for the public as well, because they wouldn't have to pay for ratings.  They would be provided for 'free'.

Unfortunately this well-intended regulation paved the way for the huge conflict of interest that contributed significantly to the housing price bubble that resulted in the Financial Crisis of 2008.  Many fixes have been proposed to make the companies more accurate and accountable.  However, these 'fixes' often require new levels of oversight and bureaucracy, or the fixes are so complicated as to be almost comical.

Disband the cartel

The solution here is not to make it more complicated.  The solution is to make it simpler.  The ratings cartel must be disbanded.  Companies should be allowed to sell bonds with or without a rating.  Investors should check ratings (purchasing them if necessary) before buying bonds.  If they cannot afford to purchase the ratings or do the research on their own, they should not purchase bonds.  Companies should, however, be required to issue a prospectus, just like they do with new stock offerings.  As has been shown in comparative studies of banking systems, government has an important role in fostering information transparency in the markets, which enables market discipline of companies by the public -- the most effective form of regulation.  Government can also take a role in educating the public about the dangers of investing in ungraded bonds.

This would bring bond ratings more in line with stock ratings, which are often offered through independent subscriber services such as Morningstar.  There are still potential conflicts of interest.  For example, during the tech bubble in the late 90's, many companies such as Enron were rated too highly by the investment banks that also supplied underwriting and consulting services.  These conflicts of interest must always be disclosed, and investors must always be wary.

There is no substitute for market discipline and investor scrutiny.  Anyone who relies on 'big brother' government to secure their investments or to learn which ones to make, is likely to be disappointed.  Investors must do their homework and take responsibility for their investment decisions.  They must be willing to pay a fee for ratings if they cannot evaluate the investment independently.  And they must continually evaluate the objectivity of the rating agencies themselves.  But because the ratings agencies know that objectivity is their lifeblood, they will always strive to maintain it.  No ratings agency would have given a triple-A rating to junk bonds under their original business model, and this alone would have significantly reduced the size of the housing bubble.

However, if ratings agencies are allowed to continue to operate as a cartel, then two things will happen.  First of all we will see history repeated, as the agencies treat investor lawsuits are simply a 'cost of doing business.'  This may take 5 years or 20 years, but it will happen.  Secondly, if more government regulation is enacted to mitigate the conflict of interest, it will create entirely new unanticipated problems and complexities that will result in future crises.  And the people and the politicians will call for even greater regulation, in an endless, hopeless cycle.