Pick Your Own Judge

Stan Honda/Agence France-Presse â€" Getty Images

Nathaniel Popper’s excellent article on rating agencies today â€" demonstrating that Standard & Poor’s seems to have improved its market share in the rating of commercial real estate securitizations by lowering its standards â€" points to what a strange market the ratings agencies are in.

For their franchises to be worth anything, they must seem to be credible to investors. But once they overcome that minimal hurdle, they will get more business if they are less critical than their competitors.

Seen in that light, the maneuvers of S.&P. over the past several years make perfect sense. In the immediate aftermath of the credit crisis â€" caused in no small part by the willingness of ratings agencies to give out AAA ratings to securities that turned out to be junk â€" S.&P. tightened up. It immediately lost market share, but improved its damaged public image.

Having re-established its credibility, it seems to have moved in the other direction to get more business.

This is a problem that has always existed with rating agencies, but when they were only rating bonds it may have been less important. Any given company chooses one or more rating agencies when it issues a new bond, and then may not make another decision for years, until it returns to the capital markets. But the decisions on who rates securitizations are made by a handful of banks that put them together. The bank making decisions on this week’s deal will be back next week, or next month, with a new one. That leaves the banks far more knowledgeable and aware of what they can expect from any given agency.

Regulation of rating agencies has, if anything, worsened the problem. They now must publish extensive criteria for their ratings. They still have leeway on rating companies, no two of which are exactly alike. But the banks know exactly what the criteria are for securitizations, and design them to conform.

Imagine, for a second, that a college maintained a list of people who could grade papers written for the history department, but the student got to decide which one marked his or her paper. You know which graders would get the business. That is sort of how it is now in securitizations.

Is S.&P. doing a worse job than its competitors now? There is no way to know. We’ll find that out, perhaps, in future years when we see how many securities are downgraded or go into default. But S.&P.’s competitors have to be sure they are not too far away from it, for fear of getting no business at all.

The solution to this does not lie in cracking down on rating agencies. It lies in institutional investors’ doing their own work and hiring their own analysts, rather than blindly trusting ratings.