S&P recently downgraded the United States’ credit rating from AAA to AA+, apparently causing some problems with the market. Interestingly, S&P has been under investigation for its rating practices prior to the financial meltdown. It has been alleged that S&P’s analysts wanted to rate the mortgage bonds at less than AAA, but they were overruled. These excellent ratings led people to put more faith in these financial instruments than was warranted, thus contributing to the financial mess.
While there is clearly a need for a rating system, the current system seems to be rather problematic. One obvious problem is that the entities who are rated pay the rating fees to companies like S&P (some states, such as the US, do not pay). For example, banks paid $100,000 or more when getting their mortgage bonds rated. Rating fees for collateralized debt obligations were significantly higher, apparently seven times so (or more). Banks allegedly shopped around looking for companies that would give them favorable ratings in return for large sums of money. That this is a recipe for disaster should be rather obvious.
To use an analogy, having rating companies being paid by the entities they rate seems a lot like having college students directly pay their professors. In such a situation, students would tend to shop around for professors who would give them the best grades and would tend to avoid professors who would provide an honest assessment. Professors, being only human, would tend to be influenced by this as well. After all, it would be much harder to assign an F or D knowing that it would no doubt impact enrollment (and income) the next semester. If such a system existed, another impact would be that the transcripts of students would not be trusted by professional schools and businesses. After all, if the students are handing cash to those who grade them, the grades will generally not be accurate.
While some might suggest handing over the rating system to the state, this does not seem to be the optimal solution. The rating companies should, of course, be subject to legal regulation to keep them from doing harmful deeds. However, their independence from any specific state seems to be important in the context of a global economy.
One appealing solution that has been suggested is having the investors pay the fees. So, for example, the folks investing in mortgage bonds would pay S&P or other companies to evaluate the quality of these bonds. This would give the rating companies an incentive to accurately assess the financial “products.” After all, a rating company that rated crap as golden would soon find itself without any customers. Given that this change would give the rating companies an incentive to rate accurately, it seems like a much better system than the current one that certainly seems to encourage over-rating.