Earlier this week, SEC Chair Mary Shapiro appeared before Congress to suggest ways to fix the failings in our credit rating agencies. Sadly her proposals miss the market, although that shouldn’t be so surprising as her suggestions appear to rest upon a misunderstanding of the problem.

The thrust of the SEC’s current approach is more disclosure, such as releasing “pre-ratings” that debt issuers may get before final issuance. Additional disclosure of ratings methodology and assumptions is likely to be useless. Almost all that information was available during the building housing bubble. The problem is that the rating agencies had little incentive to go beyond the consensus forecasts of increasing to at most modest declines in home prices. These same assumptions were the foundation of almost all government economic forecasting as well, yet few believe that forcing CBO or OMB to disclosure more of their forecasts will cure our budget imbalances. What is needed is a change in incentives.

Here again the SEC seems to misunderstand the incentives at work, but then recognizing such would force the SEC to admit its own role in creating those some perverse incentives. The SEC’s notion that agencies issue favorable ratings in order to gain business misses the most basic fact of the ratings business — they don’t have to compete for business, any debt issuer wanting to place “investment grade” debt has to use the agencies, and often has to use more than one of them. Due to a variety of SEC and bank regulations, there is almost no competition among the rating agencies. They have been given a government created monopoly. If the rating agencies were, as the SEC proposes, competing strongly for business, then they wouldn’t have been earning huge profits on that business. Competition erodes a business’ profits. During the housing boom, the rating agencies continued to make ever more profits — more the sign of a monopoly than one of competition.

The truth is not that the agencies were captive to the debt issuers, but the other way around. And like any monopolist, the agencies became lazy, slow and fat. The real fix for the failure of the credit raters is to reduce the excessive reliance on their judgements inherent in most securities, banking and insurance regulations. An investment grade rating should never serve as a substitute for appropriate due diligence on the part of investors (especially pension fund managers) or regulators.