06/27/2010 05:12 am ET | Updated May 25, 2011

Product Warranty Proposal for the Ratings Agencies

An enduring mystery of the debate about regulatory reform is the extent to which the ratings agencies are a second order issue of concern.

Firms like S&P and Moody's are Nationally Recognized Statistical Rating Organizations (or "NRSRO") and issue credit ratings that the SEC permits other financial firms to use for certain regulatory purposes. This imprimatur of legitimacy creates a lucrative revenue base for these firms; but they are fundamentally unregulated and unsupervised. Their reckless issuance of AAA ratings in combination with their quasi official status fueled the permissive atmosphere that led to an explosion in the issuance of worthless mortgage backed securities - perhaps the most immediate single cause of our financial system meltdown.

I believe that there is a simple solution if we want the managements of these firms to administer the ratings process with the degree of intellectual integrity and analytical rigor that the investing public should have expected and now should demand.

Specifically, any financial system regulatory overhaul bill should include a provision that would impose a defined liability for the rating agencies when a bond defaults. Essentially, this would be mandated product warranty. The amount of warranty coverage provided by a ratings firm would vary depending on whether a bond had been rated AAA ( in which case, if it defaults, they were really, really wrong and should have a large warranty exposure) or BB ( in which case, if it defaults, they were perhaps only slightly wrong). No warranties would be required for any bonds rated below BB on the theory that those types of bonds are, by definition, speculative and the fact that no warranty would be applicable would be a proper admonition to any potential buyer with respect to the due diligence that should be performed in connection with a purchase of such a security.

If the warranty were calculated as a variable percentage of the face value of the bond with the percentage dependent upon the initial rating ( the higher the rating, the higher the percentage) then the agencies would have a strong economic interest to get the ratings right. The ratings agencies probably would raise the prices they charge for issuing ratings due to the "product warranty" exposure. However, those price increases will be limited both by natural competition between the firms and by the fact that, over time, the very presence of the warranty exposure will lead to higher quality ratings and minimal payouts. Nonetheless, even if the cost of ratings rises somewhat, our financial system will be a lot sounder if we have a systemically higher quality ratings process.

The point of this proposal is to create a system that does not rely on a lengthy court process to determine whether the ratings agencies acted in good faith when a bond turns out to have been materially misrated; rather it is to implement a system where the ratings agencies, in return for the right to benefit from the revenue that they generate as a result of their status as an NRSRO, should bear clear liability for the quality of their work.