The SEC says it wants shareholders to know how senior executives' compensation is aligned with the financial performance of their company.
Large fixed-income investors, whose constituents were badly hurt by inaccurate ratings, and which have a prime interest in ratings accuracy, should step up and create an investor-owned ratings agency that prioritizes accuracy over revenue production.
It would seem more important that ratings agency analysts' compensation be aligned with the performance of their ratings. But no such requirement exists, and for that reason, ratings agencies pose as much systemic risk to our financial system as any organization.
The three major ratings agencies did not single-handedly cause the financial crisis, but they could, and should, have single-handedly prevented it. By assigning their highest ratings to the mortgage-related securities that subsequently defaulted, they set the stage for the financial crisis that lost so many Americans their jobs, homes and wealth.
The inaccurate ratings can be attributed to two main causes: first, internal compensation structures prioritized revenue production over accuracy and paid those responsible for challenging ratings methodologies significantly less than those who assigned ratings. Second, the resulting competition for issuer fees lowered ratings standards to gain market share, through what came to be known as "ratings shopping."
These backwards incentives seemed to trump any awareness of the importance of ratings to the health of our financial system. They were driven by the profit motive, which continues to exist within all ratings agencies, large and small.
Under the Dodd-Frank legislation there has been progress in the governance of ratings agencies. But Dodd-Frank attempts to mandate behavior that is inconsistent with human motivations. Instead, it would make more sense to start with motivations that are consistent with human nature in the first place.
Investor-owned ratings agencies would be owned by eight to ten of the largest fixed-income investors in the U.S., whose representatives would serve on the board. They would minimize ratings shopping by implementing internal compensation structures that rewarded accuracy and transparency over revenue production. Quick ratings upgrades would trigger a review as well to prevent undue conservatism and promote fairness in assigning ratings. Salary increases would reflect the quality of analysis, and investor-owned ratings agencies would pay analysts responsible for challenging ratings methodologies at least as much as analysts who assign ratings.
Bonuses could be paid over a period of years, and if the issue defaulted or was quickly downgraded or upgraded, a committee would determine the quality of the analysis. If the quality was found to be poor, the balance of the bonus would be reduced and the paid portion could be clawed back. Fixed-income investors would establish a culture that recognizes the importance of ratings to our financial system.
Under such a system, revenue production would be more than adequate. The fixed-income investors would constitute a substantial part of the market and would request (not require) that issuers get an investor-owned agency rating. The system would preserve the issuer-pay model, which is necessary to fund operations of a robust ratings agency. Issuers would comply because of the interest savings that would likely come with an investor-owned agency rating. The agency's credibility would also create demand for its ratings from investors not represented on its board.
To be sure, investor-owned ratings agencies could pose conflicts of interest. Capital-dependent fixed-income investors and fixed-income investors looking to sell particular bonds want higher ratings; prospective buyers want lower ratings. So there is understandable concern that fixed income investor representatives on the board might try to influence ratings.
These potential conflicts can be mitigated. Fixed income investor representatives would have no influence over ratings outcomes, only over internal governance. The fixed income investor representatives would have no responsibility for their employer's investment decision-making. Fixed income investors would prohibit agency board members from influencing ratings and spreading information to benefit fixed income investors.
Investor-owned ratings agencies would send a message to mutual fund shareholders, retirement plan participants and other investors that the fixed income investors have taken steps to avoid a repeat of the inaccurate ratings that contributed so heavily to the financial crisis.
Investor-owned ratings agencies offer a private-sector approach to ratings agency reform, with none of the government involvement, cost or moral hazard associated with other models that the SEC has considered. The SEC can and should explore the idea of creating an investor-owned ratings agency with large fixed income investors.
Neil Baron represented Standard & Poor's from 1968 to 1989 and was Vice Chairman and General Counsel of Fitch Ratings from 1989 to 1998. He recently advised the SEC and Congressional staff on ratings agency reform.