Solution to rating agencies problem

at the end of the day, rating agencies are just giving an opinion! holding them liable for their opinion would be unfair. their stance is you can use it at your own risk, maybe a structural change in the sense of having "regulatory" bodies rating various financial instreuments might be an idea.

an alternative proposed sometime back was that all banks should pay a certain amount to a government pot (maybe similar to the FSCS levy in the UK, which is used for paying depositors of a bank in case all go belly up!) and the rating agencies should purely be compensated from that, thus taking off any incentive they might have in the sense of giving good/bad rating because of the potential decrease in compensation for that (removing conflict of interest). That sounds like a better idea to me!

Difficult question to answer but I think your solution, though it looks good on the surface, is unworkable for two reasons:

1) Ratings agencies would be incentivised to rate everything two or three notches below what they actually believe to be the correct rating in order to "be prudent" i.e. protect themselves

2) More importantly, credit profiles can and do change - hence upgrades and downgrades. A ratings agency can't be held responsible if a business or market conditions suddenly drop unexpectedly.

Rather than the ratings agencies themselves, who will always get the wool pulled over their eyes to an extent by smarter, high paid bankers, the crisis should hopefully reaffirm what the agencies themselves state - that their ratings are merely guides as to their opinion of underlying credit quality and that anyone buying the stuff should bloody well do their homework. You wouldn't pile into a stock just because Brewin Dolphin said it was a buy so why pile into a structured credit product with no due diligence just because S&P says it is a AA credit.

Edit: This is in response to the OP. The idea put forward by the poster above is interesting. Not sure you can ever completely remove conflicts of interests - that's why we have regulators.

So you would transfer the burden to banks (or issuer if these are not banks)?

I can understand that view, but the problem with that is that Banks/Issuers still would have to keep impairments for the credit issued on their balance sheet, even after selling the structures.... And it wouldn't prevent rating agencies to try to get business by giving higher ratings than deserved (only if the banks started to worry more about the impairment reserves than with selling the products)

I was thinking something like the rating agencies having some sort of "liability insurance" like lawyers in the US or doctors aorund the world...

Also, just found this article on the subject:

http://www.ft.com/cms/s/0/28df0210-52f8-11df-813e-00144feab49a.html

Institutional investors know that ratings suggest a default risk; they don't confuse it with valuation. The problem was that a whole bunch of securities carrying a AAA rating experienced massive defaults. One of the CDO's in the Goldman lawsuit experienced defaults in 100% of its underlying loans. Every single loan defaulted, yet the ratings agencies had suggested the collective pool had a creditworthiness similar to GE bonds. That clearly wasn't analyzed correctly.

In terms of a solution - the ideas above about having some liability back to the rating agency seems like a good idea but will be hard to implement. Maybe if they offer blanket opinions on their ratings, such as "if more than 20% of our AAA rated corporate bonds default, then we will reimburse investors X..."

Investors should pay, not the banks. They want it rated, they pay the raters. Very simple.