An Example of Government Regulation Gone Amuck

Most government regulation is well-intentioned, but it often runs amuck. As a proponent of the free market, I'm always on the look-out for a good example illustrating its evils. Well, I've found a doozy.

Most of my readers know at least a little about the current credit crisis. Banks have found themselves holding billions of securities, the value of which they can't decipher because the securities were rated as being of good quality when in reality they weren't.

Three rating agencies handle the rating of securities in the US, and these are the only agencies approved by the SEC. They are Moody's, Fitch, and S&P (Standard & Poor).


[Thanks to nfib.com for the image.]

The government has put its seal of approval on these three rating agencies, and as a result these companies pretty much control the whole market for ratings. The seal of approval, the "NR-SRO" or the "Nationally Recognized Statistical Rating Organization," is supposed to tell the public that these companies have passed several government standard tests.

Mr. Egan, creator of a small rating agency named Egan-Jones, says the seal stands for "No Room-Standing Room Only." What he means is that the seal is so hard to obtain and so expensive that competitors like himself find it virtually impossible to reach for it.

Aaron Lucchetti in today's Wall Street Journal tells us the story of the Egan-Jones Rating Company, a David of an operation in a world of Goliaths if there ever was one. While S&P, Moody's and Fitch were distributing AAAs like jelly beans, Egan-Jones was dropping many of the troublesome securities to Bs. The only problem was that no one was listening.

The article does a good job of delving into the source of the problem. The big agencies' fees are paid by the issuers of the securities, creating a conflict of interest. How can the raters be impartial when their livelihood depends on the good rates they issue?

Egan-Jones's fees, however, are paid (and smartly) by their investing customers (from $20,000 to $100,000 a year for ratings and research). Egan-Jones's incentive structure is therefore the reverse, they claim.

So if you're a small company trying to elbow into a field of goliaths, get out your wallet and hire lots of lawyers. Oh, and don't forget to finagle a financial industry smash-up while you're at it, because it helps blow your competition out of the water. Egan-Jones is doing better than ever--and they might even win SEC approval soon.