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Abolish Credit Rating Agencies? Some Say So

 December 14, 2009 09:24 AM

In an article I wrote back in April of 2007,  I assigned blame to various individuals, industries, and institutions for the financial and mortgage meltdown that led us to the current financial mess we find ourselves in. One such perpetrator has received a significant amount of flak recently, and some suggest they should be restructured or even eliminated altogether. I am speaking, of course, of the credit rating agencies, such as Moody's Corp. (NYSE: MCO), Fitch's, and Standard & Poors - which is owned by The McGraw-Hill Companies (NYSE: MHP).

[Related -Personal Consumption Spending Expected To Be Flat In January]

Through further research, I compiled a list of options we have for dealing with the credit rating agencies.

Option 1: Restructure Them

In a January 3rd New York Times op-ed, columnists Michael Lewis and David Einhorn rail against the rating agencies:

"End the official status of the rating agencies. Given their performance it's hard to believe credit rating agencies are still around. There's no question that the world is worse off for the existence of companies like Moody's and Standard & Poor's. There should be a rule against issuers paying for ratings. Either investors should pay for them privately or, if public ratings are deemed essential, they should be publicly provided."

[Related -China's Rate Cut Insufficient - Investors Expect More]

Those are some pretty harsh words, Mr. Lewis and Mr. Einhorn, but as a professional investment adviser I happen to agree with you. Issuers buying ratings from rating agencies to sell investors securities is akin to an individual (issuer) buying a credit score (rating) from Experian (rating agency, who is competing with other rating agencies for business) then going to any number of banks (investors) to apply for a loan (security).

As you can imagine, the individual wants a good credit rating from Experian, and Experian desperately wants the individuals' business, so their incentives are aligned. But what about the bank's incentive? Their incentive is to make sure their money is safe, but they only have this Experian rating to rely on. Too bad for the bank.

Option 2: Eliminate Them

I like Mr. Lewis and Mr. Einhorn's ideas, but I found another viewpoint that I might like even more. Financial blogger Paul Kedrosky takes it one step further and suggests that rather than restructuring these entities, we should do away with them altogether. Mr. Kedrosky correctly points out that there is no regulatory oversight for equities, which begs the question: Why don't we just let the private investors rate these securities, like they do with equities? Sure,  private investors don't always value equities perfectly, but obviously rating agencies don't either.

Option 3: Increase Oversight

Yuck. I don't even want to think about this option. But if any of you think this one is a good option, please share your thoughts.

Option 4: Do Nothing

I doubt many of you think that we should do nothing. The credit rating agencies really messed up and led investors to slaughter by not recognizing (or perhaps willfully ignoring) risks in the products they rated. But again, I'm willing to hear any opinion out.

Freund Investing Managing Member Ryan Freund holds no position in any of the companies mentioned in this article. Freund Investing has a solid Disclosure Policy.

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