The Credit-Rating Mystery Solved

Last week, Treasury Secretary Hank Paulson said the housing meltdown hasn't hit bottom, and he sharply criticized credit-rating agencies for failing to recognize the risks in hundreds of billions worth of mortgage-backed securities whose values continue to plummet as home-loan defaults grow.

The SEC, Treasury, and several congressional committees are now investigating why credit-rating agencies such as Standard & Poors, Moody's, and Fitch gave thumbs up for so long to securities backed by sub-prime mortgages -- downgrading them only in July, after almost everyone on the planet knew they were junk. I mean, you didn't have to be a rocket scientist to know that mortgage lenders had been pushing low-interest mortgages on people who wouldn't be able to repay them once interest rates rose.

The answer is simple: Credit-rating agencies are paid by the same institutions that package and sell the securities the agencies are rating. If an investment bank doesn't like the rating, it doesn't have to pay for it. And even if it likes the rating, it pays only after the security is sold. Get it? It's as if movie studios hired film critics to review their movies, and paid them only if the reviews were positive enough to get lots of people to see a movie.

Until the recent collapse, the result was great for credit-rating agencies. Profits at Moody's more than doubled between 2002 and 2006. And it was a great ride for the issuers of mortgage-backed securities. Demand soared because the high ratings expanded the market. Traders that bought, rebundled, and then sold them didn't examine anything except the ratings. It was actually a market in credit ratings -- a multi-billion dollar game of musical chairs. Then the music stopped.

So what exactly are the SEC and Treasury and Congress investigating? It's obviously a giant conflict of interest -- exactly like the stock analysts who, before the dot-com bubble burst, advised clients to buy stocks their own investment banks were issuing. The remedy for that was to split the two functions -- analysis from investment banking.

The remedy here is to do much the same: Bar issuers from paying credit-rating agencies. If investors want to examine an issuer's credit ratings, they or the pension or mutual funds they invest through can subscribe for the service -- just as movie-goers subscribe to publications where reviews appear. Stop all the investigations and issue this rule.

This column is adapted from Reich's weekly commentary on American Public Radio's Marketplace.

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