Watching the Watchers

Credit-rating agencies exist to evaluate the safety of debt securities. Imagine for a moment that they had done their job when financial go-getters began churning out bonds backed by sketchy loans and the dream of endlessly rising home prices. Properly labeled as junk, those bonds would have found few buyers. Denied access to the vast reservoirs of capital held in mutual, money-market, and pension funds, the go-getters would have ended up as minor players. And millions of Americans might still have the jobs, homes, retirement savings, and economic security they lost.

Now imagine what it would take to get the rating agencies to do their job properly. The problem is one of glaring, undisputed, inescapable conflict of interest. Why did the rating agencies gloss over the huge risks of mortgage-backed bonds and collateralized debt obligations? Because that was the way to attract business from the securities issuers who paid them, picked them, and, in many cases, had their help structuring securities to achieve the desired rating.

The first imperative of reform, then, is to align the incentives of these badly corrupted entities with their mission. The most promising proposal, outlined in a policy paper by David Raboy, an economic consultant to the congressional panel overseeing the bailout, envisions an independent clearinghouse to collect fees from securities issuers and assign bond offerings to ratings agencies at random. This would be a game changer: The rating agencies, which have lately become Wall Street players in their own right, would go back to being the cautious, green-eyeshade types they once were -- and the cool observers of the bond market that we need. Their executives and lobbyists would holler in protest; that, too, would be a plus.

But, sadly, the rating agencies have not had to do any hollering. Under the terms of the financial-reform measure pending in the Senate Banking Committee (and of the similar set of reforms approved by the House of Representatives in December), these important gatekeepers will go right on being paid by those seeking to go through the gate.

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The rating agencies started out selling information, in printed form, to large investors. That was still their line of business -- a good and useful one -- in the 1930s, when federal regulators told the nation's banks to invest only in "investment grade" bonds as determined by the Big Three, composed then as now of Moody's, Standard & Poor's, and Fitch. In subsequent decades, federal and state watchdogs handed down many similar rules, requiring brokerage houses, insurance companies, and pension funds to base their investment decisions on credit ratings and giving official recognition to the established firms.

In the 1970s, modern photocopying machines undermined the original business model of the rating agencies by allowing investors to obtain ratings materials without paying for them. One by one, the rating agencies sought and obtained the approval of the relevant regulators to move from an investor-pays to an issuer-pays model.

The perils of the new arrangement were not fully revealed until the late 1990s, when the balance of the rating business began to shift away from straightforward bonds issued by corporations and public agencies toward mortgage-backed securities and the other complex products of modern "structured finance." The government-sponsored housing agencies Fannie Mae and Freddie Mac had been securitizing mortgages for decades. Wall Street firms put a new spin on the practice, however, by bundling thousands of loans together, carving out repayment rights in the form of "tranches" of bonds (each representing a different place on line in the event of repayment trouble) and claiming that this alchemy could transform high-risk loans into low-risk bonds.

Because most of the underlying mortgages involved teaser interest rates and other short-term lures, millions of borrowers faced payments they would have no way of making a few years down the road, unless continued increases in housing prices allowed them to refinance into lower-cost loans or pull out cash to buy time. Like sidewalk shell-game artists, the mortgage companies and their Wall Street partners used the razzle-dazzle of tranches and other fancy forms of "risk management" to divert attention from what really mattered -- any significant downturn in the housing market was bound to bring massive defaults and foreclosures. And the rating agencies went along, bestowing triple-A ratings (equivalent to the rating of U.S. Treasury bonds) on the vast majority of the roughly $3.2 trillion in mortgage-backed securities sold between 2002 and 2007.

In 2004 and 2005, Standard & Poor's and Moody's lowered standards again and again, as each sought to avoid the perception that it might be even marginally less accommodating. "I knew it was wrong at the time," S&P director Richard Gugliada testified later, adding that "it was either that or skip the business."

There turned out to be plenty of loot to go around. While the quality of their work deteriorated, the combined profits of the rating agencies swelled from $3 billion in 2002 to over $6 billion in 2007; their CEOs meanwhile earned a collective $80 million. Moody's, whose profits quadrupled between 2000 and 2007, had during five of those years the highest profit margins of any company in the S&P 500. The secret of that fabulous success was the power to dispense something precious -- an investment-grade rating -- without any sense of duty to properly investigate, or even fully understand, the bonds in question.

The mission that these companies so thoroughly betrayed is a crucial one. Even if regulators take steps to reduce investor reliance on ratings, as both the House and Senate reform measures urge, rating agencies are needed to help investors accurately price risk and to allow issuers of bonds -- from small municipalities to large corporations -- to compete for credit in a national market.

Some have called for the creation of a public rating agency. That would hardly be a radical step. We expect our government to safeguard us against crash-prone cars and airplanes; why not against crash-prone financial instruments?

But a case can also be made for multiple voices and competitive forces, and Raboy made it well in his January 2009 policy paper commissioned by the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP). Raboy's ingenious plan calls for the creation of an independent clearinghouse -- most likely within the Securities and Exchange Commission -- to receive rating applications from securities issuers and then farm out assignments in a random or unpredictable way

The funding, which could come from a financial-transaction fee, would need to cover the operations of the clearinghouse as well as the ratings process itself. The performance of the rating agencies would periodically be compared on the basis of simple, transparent criteria, such as the number of times that investment-grade bonds defaulted or lost significant value. The most accurate rating agencies could be rewarded with additional assignments. Those with the poorest records could, in extreme cases, be suspended or removed from the pool.

The clearinghouse idea would solve the perverse-incentives problem with one blow. It could have other advantages as well. Under the current system, rating agencies get paid, as a rule, only if they come through with a rating; the clearinghouse could compensate them even for concluding that a particular set of securities was just too complicated to rate. Up to now, that healthy possibility has not been considered. "We rate every deal," a Standard & Poor's analyst grumbled in an instant message to a colleague. An offering "could be structured by cows," the analyst added, "and we'd rate it."

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In the wake of the financial meltdown, a tidal wave of rage briefly overran the usual lines of ideology and political calculation. "We've got to deal with the conflicts," Sen. Richard Shelby, a Republican from Alabama and the ranking minority member of the Senate Banking Committee, declared in a January 2009 exchange with Mary Schapiro, the Obama administration's choice to head the Securities and Exchange Commission. Schapiro earnestly agreed and so did the committee chair, Chris Dodd of Connecticut.

Shelby, Schapiro, and Dodd were three of many influential figures who initially had no trouble diagnosing what ailed the rating agencies but who have since been unable to convert their own logic into tough-minded remedial action. Dodd's version of financial reform, like that of his House counterpart, Barney Frank of Massachusetts, comes at the rating-agency question from every angle except head-on.

Both call for stronger SEC oversight, more ratings transparency, and greater even-handedness in the treatment of municipal and corporate bonds; both require each rating agency to have a clearly stated methodology and appropriate compliance machinery; and both would give new legal recourse to investors. (This is the gutsiest component of the Dodd and Frank plans: The ratings agencies would no longer be allowed to make heaps of money from their quasi-official role as guardians of the line between speculation and investment, and then, when their ratings turn out to be worthless, pose as mere publishers of "opinions" enjoying the unlimited protection of the First Amendment.) But both leave the basic, thoroughly corrupt business model of the rating agencies untouched.

That is a failure of vision as well as nerve. The goal of financial reform, as Dodd, Frank, and too many others in Washington seem to conceive it, is merely to reduce the likelihood of another disaster. They must aim higher, toward a financial economy that is truly an instrument of the real economy. At the moment, America needs nothing from the financial sector more than fully functioning, trustworthy credit markets. No step could do more to achieve that result than the kind of wholesale reform of the rating agencies that is, tragically, not yet on the table.

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