Credit Raters Should Follow American ‘Idol’ Judges

“American Idol” is the most watched television show ever. Steven Tyler and the other judges do a fine job rating contestants. But the judging skills of the big 3 credit raters have failed the US Investing public. And now the US Congress is in the process of pulling their prime time status.

Whats the lesson here for credit raters? Investors vote thru their wallets. Assets are worth what the marketplace is willing to pay… No more no less. Its common knowledge that credit ratings can be easily derived from asset prices by using market implied credit ratings. These ratings are in place for all municipal bonds at bondview.

The even prescient Bart Chilton, commissioner on the U.S. Commodity Futures Trading Commission has some good comments about all this.

On Aug. 5, the Standard and Poor’s rating agency downgraded the United States from AAA to AA+. That news ran across front pages. Since the early 1900s, when ratings began, this was the first time the United States wasn’t rated AAA.

S & P’s downgrade was based upon its view that Washington politics remain unstable and therefore deficit-reduction measures will not be attainable. Additionally, their decision was fueled by a $2 trillion calculation “error.” The direct impact on markets was colossal. The Monday following the release of the rating, the Dow dropped 635 points!

Remember, some of these agencies (like S & P) are the ones who got ratings so very wrong a few years ago. Not only did they give favorable ratings to firms that ultimately went under during the economic fiasco, they maintained AAA ratings on pools of junk mortgages packaged by Wall Street banks, trading away credible ratings for the bottom line of the ratings agencies. Do we really want to continue to rely upon such agencies?

Now consider “Idol” judge Steven Tyler (the flamboyant Aerosmith front man). He provides insightful commentary based upon his music and performance experience. What he says colors contestant performances with a professional texture viewers might not otherwise notice. What he and the other judges do not do is render the final judgment. That’s up to the viewers.

Ratings agencies need to be more like “Idol”: providing information, but not making final judgments that drastically influence outcomes. They should be more informative and insightful, but not deterministic. They’ve become excessively powerful and create a self-fulfilling prophesy about what markets will do. As one member of Congress asked the heads of the ratings agencies, “How could you possibly make that kind of a decision based on an opinion when you have millions of people relying on that?”

Furthermore, smaller ratings agencies should be encouraged to compete, rather than relying upon three agencies comprising 97 percent of all ratings. Importantly, agencies should work for consumers, not deal makers – a business model that incentivizes agencies to provide favorable ratings.

As Tyler sings, it’s time to stop “Livin’ on the Edge” of the financial teeter totter subject to faulty ratings agencies. We need to change the way the raters operate. We have seen the damage they can create and we should accept the status quo “No more, no more.”