Ratings agencies are back in the news thanks to a mammoth opinion out of an Australian court holding Standard & Poor's responsible for losses on structured debt products.
There is no doubt S&P did a stupendously poor job rating the products. For a quick summary of some of the problems revealed in the 635,000 word judicial opinion, see Felix Salmon's post.
I'm not sure, however, that this type of ruling will ever be carried over to the United States.
Australia doesn't have anything like our First Amendment guarantee of freedom of the press and freedom of speech. It's common law protects political speech but even that allows for far more restrictions than would be acceptable in the United States. (Read More: Standard & Poor's Found Guilty of Misleading Investors.)
The ratings agencies are shielded by the First Amendment because what they do is offer opinions about the quality of debt, companies, and other financial products. Except in some limited cases, the "end-users" of these opinions — investors — don't have any explicit right to rely on them that would give rise to agency liability.
This frustrates nearly everyone who pays attention because it is so obvious that the ratings agencies are not like most private actors. They benefit from government favoritism in a host of ways, including government rules that explicitly incorporate the ratings into requirements and shield the major companies from upstart competitors.
Nonetheless, it is almost certainly a bad idea to pare back the First Amendment protections of the ratings agencies. The exceptions we create for the agencies will be applied to other cases — this is the way law operates. You create RICO to destroy the Mafia, and you end up using it on abortion protestors and white-collar criminals.
It would be better to simply remove the various legal privileges accorded to the ratings agencies. Unfortunately, the task of trying to remove ratings requirements from our regulatory and legal structure is proving to be lengthy, complex and perhaps impossible. Governments and private investors want to rely on something and the ratings agencies happen to be their, willing to offer seemingly informed opinions.
A better idea might be to crack down on the basic business model. I'm not talking about reforming the way the agencies are compensated. There's no evidence that the "issuer pays" compensation model was the problem with the ratings or that a "investor pays" model would work better. In this day of easily transmittable information, investor pays is probably not feasible in any case.
Instead, we could restrict the access that ratings agencies have to non-public information, perhaps along the lines that we ban selective disclosure under Regulation FD. An issuer could be banned from disclosing to a ratings agency any information that it does not generally disclose to the public. All ratings would be based on public information.
As Cheryl Evans pointed out in a paper published in the Summer 2012 Valparaiso University Law Review, this could make the ratings business more competitive and therefore more competent. The agencies would be subject to competition from Wall Street investment banks, for example.
(Read More: World's Safest Banks.)
Evans worries that ratings might become less accurate under this regime but I doubt it. The loss of confidential information would most likely be outweighed by the benefits from competitive rating.
In short, instead of regulating the output of ratings agencies, let's regulate the input.
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We're on Google Plus too! Click here for John's Google+ page.
Questions? Comments? Tips? Email us at NetNet@cnbc.com or send a text message to: 917-740-8477.
Call us at 201-735-4638.