In an op-ed in the New York Times this morning Jerome Fons and Frank Partnoy point out the limitations of bond-rating agencies and in effect call for an abandoning of their use:
The only way out of the trap is to reduce reliance on ratings. First, regulators should undo the regulation web they began creating during the 1930s. The Securities and Exchange Commission has called for eliminating reliance on ratings, but that proposal has stalled in the face of intense lobbying.
For their part, investors should stop putting ratings-related language into financial contracts. The terms of credit default swaps and other derivatives should be free of ratings-based triggers. Banking supervisors should insist that loan contracts not refer to ratings. Fund sponsors, pension plan administrators and insurance regulators should remove ratings-based criteria.
The financial markets can function without letter ratings. Instead of relying on arbitrary letters, regulators and investors should consider all of the information available about an investment, including market prices.
Finally, regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.
Ratings, whether of bonds, movies, or anything else are used by people without experience or judgment as a substitute for experience and judgment. In virtually every field those without experience or judgment far outnumber those who possess them and, indeed, there’s a sort of Gresham’s Law involved: the bad crowds out the good.
I wouldn’t expect an end to relying on bond agency ratings any time soon.
