"A lot has been said and written about the role of credit agencies in the current crisis."

Another post via Emre Deliveli's Blog On Economics. From the World Bank:

"Reforming the Credit Rating Agency Industry

A lot has been said and written about the role of credit agencies in the current crisis. Almost everyone agrees that its role has been negative( CRIMINAL. FRAUD. COLLUSION ), understating( FALSIFYING ) the risk of many financial products and papers and misleading ( FIDUCIARY MISMANAGEMENT )many investors. But how can the incentive structure of this industry be reformed( A DIFFERENT PAYMENT SYSTEM )? Is tougher regulation the response( TOUGHER SUPERVISION )? Or perhaps more competition in a three company industry( A CARTEL. COLLUSION. THE BIG THREE SHOULD BE AT LEAST SHUNNED )?

A recent theoretical paper by Patrick Bolton, Xavier Freixas and Joel Shapiro (The Credit Ratings Game) offers some suggestions towards reform of the industry, but also clearly shows that there are no silver bullets. As any theoretical model, it relies on simplifying assumptions( IT ALWAYS DOES ), but it presents very clearly the incentives faced by different stakeholders, including credit rating agencies and issuers of securities, and how different policy measures will affect them. At the core of the incentive problem is the fact that it is the issuers who buy ratings rather than the "users", i.e. investors, and that issuers can shop around for good ratings( CONFLICT OF INTEREST ).

Their model is relatively simple, but the results depend critically on the existence of naïve investors who believe the credit rating agencies’ stated ratings alongside sophisticated investors who form their own opinion. The issuers of commercial paper will never buy a bad rating, so credit agencies have an incentive to overstate the quality of any given issuance if the reputation costs (i.e. future lost profits) are low enough or the share of naïve investors large enough( OK ). An increase in the number of credit agencies, i.e. more competition, makes investors actually worse off as it gives issuers more opportunity to shop around for a good rating( TRUE. BUT THE METHOD OF PAYMENT IS KEY ).

The Cuomo plan (named after NY Attorney General Andrew Cuomo) to require up-front fees before the rating is published provides credit agencies with better incentives( NOT REALLY ) to rate truthfully, but does not prevent issuers from shopping around for good ratings. An improvement upon this plan would be to prohibit shopping( A TERRIBLE IDEA ), so that issuers are tied to one credit rating agency (similar to enterprises having to choose one auditor for their financial statements). An alternative reform suggestion is to go back to investor-paid ratings – as done in the U.S. until the early 1970s – and use a transaction tax to overcome the free-rider problem.( THAT'S BETTER )

All three suggestions, however, raise moral hazard concerns, as credit rating agencies have reduced incentives to properly assess and rate new papers. This is a risk that in turn calls for proper regulation and supervision( I LIKE THIS BETTER ) of the credit rating agencies industry, including significantly increasing reputational costs( I'M FINE WITH THAT. YES. ).

Some good ideas. I like:

1) Investor Paid Ratings

2) Supervision

3) Increasing Reputational Costs

Finally, I would limit their ratings to clearly defined investments, leaving CDSs and CDOs to be done by investors. If 1 is implemented, I could accept that.