Limitations of Credit Rating Agencies

A part of the recent financial crisis has been blamed on credit rating agencies who did not rate certain securities properly. In particular, we all know in hindsight that a lot of the packaged “AAA” CDOs were in fact much more risky than the ratings given to them.

California Attorney General Edmund Jerry Brown Jr. has asked a state court to compel Moody’s Investors Service to comply with a subpoena from his office for information on its role in the financial crisis. Brown wants the rating agency to explain how it came to assign its top ratings to securities that were backed by risky subprime mortgages and other assets that later turned toxic.

In my opinion, the existing system is fundamentally flawed as the issuers of securities would pay credit rating agencies to rate their products. There is conflict of interest inherent in the system as there would be a bias towards giving better ratings.

I think a better way of administering this is to have one central government body that all issuers of securities products would have to pay a fee to whenever they have a new product that needs to be rated. The government body would then pay independent credit agencies to evaluate the products. Using this system, the government body would become the pay master of the credit agencies.

Although this is still not perfect, at least it would be better than the current system.