Last night’s TV news showed finance company bosses pleading for compulsory ratings in their industry. They presented ratings as an obvious fix for confidence now that five companies that have failed in two years, owing more than $1bn.

Their consensus warns us to tread very carefully. An industry consensus so often forms around what will best create and shelter a privileged club. They love rules that exclude “disruptive” newcomers, the guys who challenge the rules. 

The uncritical acceptance of that plea for compulsion is especially bizarre given the beating rating agencies are now taking internationally. The latest Economist surveys the scene. At the very moment Commerce Minister Lianne Dalziel offers ratings as a remedy, without apparent challenge from financial journalists, rating agencies are blamed for the catastrophe unfolding around securitization of the US sub-prime mortgage market. Michael Cullen’s cooler response was sensible.

 Overseas it is not high risk finance companies on the fringe of the financial system that are exposed as foolish. The international casualties include major banks, apparently led into unwise investment by reliance on rating agency appraisals.  

Rating agencies will be be risk averse for some years to come. Unfamiliar loan portfolios will be penalised. It will be harder to start a finance company (most agencies will not rate them without years of history). Compulsory rating is effectively regulatory contracting out. Overseas “experts” will apply crude rule of thumb investment rationing, based on their experiences in whatever market is currently the most troubled.

This is not necessarily a worse outcome than direct bureacratic rule-making (by the MED or the Securities Commisssion) but it does suggest we consider carefully how much better it would be than our current set-up.

I suspect there is a good case for strong incentives for rating, and state funded rating of the rating agencies, but not a de facto entry barrier through the rating requirement. 

The objective should not be to eliminate collapses. We’ve needed some. Irrationality has been rewarded for too long.

It has been obvious that many finance company interest rates have not been high enough to match their risk. The rates have not properly discriminated between the dodgy companies and the rest. The margins between risk free lending (government bonds) and bank and finance company investment have been too small. Reserve Bank governors have warned of a bubble in property prices. Plainly those who make the riskiest loans to developers are risky themselves. 

Without the occasional loss in high risk areas, careful people are made foolish and risk takers are rewarded disproportionately.

Mostly the risks have been discoverable from the compulsory disclosure documents, to those who know how to compare them. That does not include me. Careful reading of a prospectus is useless on its own. Prospectuses and investment statements are among the biggest (of many) frauds in that fraudulent regime called Securities Law.

Though I have a university diploma in accounting and have written many prospectuses I would not dream of relying on my own analysis. Comparison is everything in investing. To compare you need to know what the figures mean in relation to market norms. That in turn requires more knowledge and day to day involvement than can ever be maintained by ordinary people.

The law is written around the patent falsehood that if only issuers can be forced to print enough truth about themselves, the punters can make wise informed decisions. That is as silly as telling people they should work out the difference in value between a Rolls and a ‘top of the line’ Russian limo from their technical specifications. Instead it is the market that tells you, from the countless judgments built into traded prices. The assessments become reputation. Sources include mechanics, anecdote, journalists, prizes, gossip, insurers, rumour, buyers and sellers.

Securities law tries to ignore the information intermediaries. Indeed New Zealand’s pre-prospectus publicity law and insider trading law try to make illegal much of what they do. Then the authorities blame the poor punters when they can not work out for themselves what is a good investment and what is not.

Using rating agencies instead of prescription is probably less risky than giving even more regulatory power to those currently exercising it. But new law should focus on the integrity of ratings as comparisons, not on their intinsic reliability in predicting disaster. Honest agencies should probably get legal protection against hindsight liability.

And there should remain room for companies to start and to operate without ratings, on the basis that if and when they fail, the first investor to complain (other than about dishonesty) should be paraded publicly as a prime rated whinger.

It is time our Securities Commission used chump examples to help punters learn what they should understand for themselves and what they can not. The Australian Securities Commission used to be very good at that.

Instead our Commission is busy setting up a regime to make respectable the whole financial advisory industry, when much of it is  charlatanry.