Proposal to Break Up Rating Agencies

As rating agencies came into renewed focus this week as a result of Senate Banking Committee hearings on their role in the structured credit mess, one suggestion appears to have been gotten little play in the financial media.

Yesterday, the Financial Times reported that Eric Mindich, CEO of Eton Park Capital and newly appointed head of a government advisory panel on hedge funds, said rating agencies needed to be split up to reduce their conflicts of interest. This idea parallels the post-Enron requirement that accounting firms separate their consulting business from their audit function.

For the rating agencies, the analogy is to separate the rating function from advisory services. And what is interesting is that the proposal comes from a senior member of the financial services industry, rather than, say, an academic.

From the Financial Times:

Credit ratings agencies need to separate their rating and advisory functions because of conflicts of interest in their relationship with Wall Street, the newly appointed head of a high-level government advisory panel said yesterday.

Eric Mindich, who was named on Tuesday as head of a private sector group advising the White House, said investor confidence in the ratings agencies had been “severely damaged” and that their business model had inherent “serious -conflicts”.

“I do not think that the market can discipline ratings agencies sufficiently,” said Mr Mindich, chief executive of Eton Park Capital and a former colleague of Hank Paulson, the Treasury secretary, at Goldman Sachs, the investment bank.

Mr Mindich said he was concerned that agencies issue ratings and also advise issuers of securities on how to secure better ratings. He suggested it might be necessary to separate those functions or require agencies to provide detailed disclosure of their contact with clients.

Lawmakers and investors criticised the companies for giving high ratings to subprime securities and failing to act quickly when borrowers began defaulting on loans backing the bonds.

Ratings agencies publish their judgments on credit-worthiness to help assess the risk of investments. Their performance has been criticised in the wake of the credit squeeze that has hit capital markets. Last month the European Commission announced an investigation into their slow reaction to the subprime crisis….

Larry Summers, the former US Treasury secretary, said there were obvious conflicts of interest in the ratings industry: “If you are hired by someone at twice your regular fee to work collaboratively with their people to design a security that will receive a triple A rating from yourself” you are likely to deliver certain results. “There needs to be a lot of cleaning up in this area.”