The following is a guest post by Kenneth Posner, author of “Stalking the Black Swan: Research & Decision-making in a World of Extreme Volatility.” The opinions expressed are his own.
Recently, the U.S. Financial Crisis Inquiry Commission (FCIC) held hearings on the role of the rating agencies in the near-death experience of the U.S. financial system, an important topic given the disastrous performance of mortgage-backed securities rated AAA by Moody’s and Standard & Poors.
The problem with the rating agencies is not their role, but the oligopolistic domination of the business by these two firms. This domination is a direct result of the “issuer-paid model” under which rating agencies are paid by the issuers of securities, rather than investors.
To reduce the risk of future crisis, we should eliminate the issuer-paid model, returning the rating agencies to their roots as investor-paid businesses. This reform would create room for a larger number of rating agencies, restore incentives for quality and accuracy, and encourage more prudent decision-making by investors, regulators, and financial institutions.
Investor-paid is a viable business model, as one-third of Moody’s revenues during 2008-9 came from subscription fees for research, data, analytics, and risk management software, with healthy margins in excess of 40%. (The other two-thirds of revenue came from issuer-paid ratings).