Here we go again - another financial mess with credit rating agencies in the cross hairs. This is nothing new. Over the last four decades, credit rating agencies have been associated with several major financial disasters: the bankruptcy of Penn Central Transportation Company in 1970, the bankruptcy of Orange County in 1994, the Asian financial crisis in the late 1990's, the bankruptcy of Enron in 2001, and the bankruptcy of WorldCom in 2002.

Currently, the United States is suffering from an economic crisis precipitated largely by the deterioration of mortgage-backed securities. The process of securitizing mortgages is complex and involves many players. The current financial system relies on each player in the process to perform due diligence on the mortgages underlying each investment pool.

Federal regulators have recently discovered that investors, including large financial institutions, failed to properly perform due diligence on mortgage-backed securities. Instead, they relied almost entirely on the credit ratings agencies who, in their own right, failed to adequately measure or communicate the risks of the mortgage-backed securities market. This set the stage for an economic meltdown of unprecedented complexity.

In this article, I explain why credit rating agencies have come to play such an important role in regulating the financial markets and why they are essential in considering future reforms to the financial system. I also address problems within the credit rating industry and explain why recent regulation fails to adequately address these problems. Finally, I propose a handicapping system that encourages credit rating agencies to properly rate mortgage-backed securities in the future.

This handicapping system will be similar to handicapping in horse racing and golf. However, unlike horse racing and golf - where handicaps level the playing field by giving the worst golfer or horse an advantage - these handicaps will penalize the worst credit rating agency, and vice versa. In this, handicapping the credit rating agencies will reduce or enhance an agency's rating depending on their past performance in rating similar types of securities.

Credit rating handicaps will also be similar to the ratings themselves because they will be an easily understood symbol. But, instead of predicting whether a company will default on its financial obligations, credit rating handicaps will predict whether an agency's ratings will be accurate. This will negate externalities that currently plague the credit rating industry and will force credit rating agencies to consider regulatory consequences for issuing inaccurate ratings. Ultimately, this will transform credit rating agencies into a credible regulator within our financial system.