Grading the Graders

With the markets in turmoil, familiar questions arise about the bond-rating agencies.

ATTENTION, subprime mortgage bond market shoppers: Moody's Investor's Service has just lowered its ratings of 691 securities issued last year and originally worth $19.4 billion. The bonds were backed, in large part, by "piggyback" loans -- loans that people take out to make down payments on houses. Seventy-eight of these bonds started out with the agency's top Aaa rating, but Moody's cites "the dramatically poor overall performance" of similar subprime loans as a reason to downgrade them.

Now they tell us.

Small wonder that, as the scary subprime shakeout continues, Congress and the European Union are turning their attention to the bond-rating agencies: Moody's, Fitch Ratings, and Standard & Poor's. The agencies stand accused of enabling the crisis by slapping investment-grade labels on dubious subprime-backed securities -- long after it should have been clear that the bonds were much riskier. House Banking Committee Chairman Barney Frank (D-Mass.) is promising hearings in the fall, and the European Commission has announced an investigation.

In a perfect world, investors would have all the time and information they need to size up the risks and rewards of every financial instrument in the market, and they would do so conscientiously. In reality, they rely on bond-rating agencies to help them make what are often competition-driven snap judgments -- and, of course, not all money managers would rather face the unvarnished truth than make a buck. The agencies are bound by self-interest and professional ethics not to take advantage of this situation. Yet a contradiction is built into the rating agencies' business: They get their information -- and their fees -- from the investment banks that underwrite the securities the agencies rate. You can see how this might lead to grade inflation from time to time.

We suspect that the investigations cranking up on both sides of the Atlantic will rediscover this familiar issue. There is no obvious regulatory fix, though possibly the solution lies in forcing out more information from the secondary mortgage market, as Mr. Frank has suggested. The burgeoning market in "credit default swaps" provides an alternative way of gauging the riskiness of bonds; the current crisis may enhance the swaps' role at the expense of the credit agencies. Already, Moody's and McGraw-Hill Cos. (which owns Standard & Poor's) have been punished, harshly, in the way that probably matters most to them: Their stock prices have fallen dramatically since the beginning of the year. But the credit-rating agencies have long claimed insulation from both legal liability and government regulation. With that kind of protection comes heightened responsibility, as the bond raters are about to be reminded, properly, by government in the weeks ahead.